Risk-Sensitive Consumption and Savings under Rational Inattention

This paper studies the consumption-savings behavior of households who have risk-sensitive preferences and suffer from limited information-processing capacity (rational inattention or RI). We first solve the model explicitly and show that RI increases precautionary savings by interacting with income uncertainty and risk-sensitivity. Given the closed-form solutions, we find that the RI model displays a wide range of observational equivalence properties, implying that consumption and savings data cannot distinguish between risk-sensitivity, robustness, or the discount factor, in any combination. We then show that the welfare costs from RI are much larger for risk-sensitive households than any other observationally-equivalent settings. Thus, a potential method for testing risk-sensitivity vs. robustness is to ask agents how much they would pay to receive better information about the state of the world