We develop a dynamic stochastic general equilibrium (DSGE) model with rational inattention and compare its predictions to data. Households and decision-makers in firms have limited attention and optimally allocate their attention. Rational inattention is the only source of slow adjustment. The model matches the empirical impulse responses to monetary policy shocks and aggregate technology shocks. At the same time, profit losses and utility losses from inattention are very small. Furthermore, it matters whether one uses this model or a conventional DSGE model for policy analysis.

We derive a closed-form expression for the posterior probability of Granger noncausality in a gaussian vector autoregression with a conjugate prior. We also express in closed form the posterior probability of Granger causal priority, a more general relation that accounts for indirect effects between variables and therefore is suitable in a multivariate context. One can use these results to answer the classic question, “Is variable z relevant for variable x?” and to choose variables for a vector autoregression.

Decision-makers often face limited liability and thus know that their loss will be bounded. We study how limited liability affects the behavior of an agent who chooses how much information to acquire and process in order to take a good decision. We find that an agent facing limited liability processes less information than an agent with unlimited liability. The informational gap between the two agents is larger in bad times than in good times and when information is more costly to process.

This paper presents a model in which price setting firms decide what to pay attention to, subject to a constraint on information flow. When idiosyncratic conditions are more variable or more important than aggregate conditions, firms pay more attention to idiosyncratic conditions than to aggregate conditions. When we calibrate the model to match the large average absolute size of price changes observed in micro data, prices react fast and by large amounts to idiosyncratic shocks, but only slowly and by small amounts to nominal shocks. Nominal shocks have strong and persistent real effects.

We review the recent literature on rational inattention, identify the main theoretical mechanisms, and explain how it helps us understand a variety of phenomena across fields of economics. The theory of rational inattention assumes that agents cannot process all available information, but they can choose which exact pieces of information to attend to. Several important results in economics have been built around imperfect information. Nowadays, many more forms of information than ever before are available due to new technologies, and yet we are able to digest little of it. Which form of imperfect information we possess and act upon is thus largely determined by which information we choose to pay attention to. These choices are driven by current economic conditions and imply behavior that features numerous empirically supported departures from standard models. Combining these insights about human limitations with the optimizing approach of neoclassical economics yields a new, generally applicable model.