Rational Inattention and the Dynamics of Consumption and Wealth in General Equilibrium

We use a recursive utility version of a basic Huggett (1993) model to study the cross-sectional dispersion of consumption and wealth (relative to income). The basic model implies too little dispersion compared to the data, whereas a one-parameter extension to include rational inattention (limited information processing) delivers a better fit to both facts in general equilibrium. In particular, intertemporal substitution plays an important role in determining the two key dispersion moments via affecting the degree of optimal attention in equilibrium. Alternative models that rely on habit formation, incomplete information about current income, or borrowing constraints are not consistent with the facts we document.