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This paper develops a dynamic stochastic general equilibrium model with rational inattention. Households and decision-makers in firms have limited attention and decide how to allocate their attention. We study the implications of rational inattention for business cycle dynamics. We find that the impulse responses of prices under rational inattention have several properties of empirical impulse responses: (i) prices respond slowly to monetary policy shocks, (ii) prices respond faster to aggregate TFP shocks, and (iii) prices respond very fast to disaggregate shocks. As a result, profit losses due to deviations of the actual price from the profit-maximizing price are an order of magnitude smaller than in the Calvo model that generates the same real effects. We also find that consumption responds slowly to monetary policy shocks. For standard parameter values, deviations from the consumption Euler equation are cheap in utility terms, implying that households devote little attention to the consumption-saving decision.

Business Cycle Dynamics under Rational Inattention