Christopher A. Sims is a pioneering economist who has made significant contributions in macroeconomics and time series econometrics. He is best known for developing the Vector Autoregression (VAR) model and the theory of Rational Inattention. The theory of Rational Inattention proposes that economic agents face constraints on how much information they can absorb and process when making decisions. This theory provides a micro-foundation for inertia, stickiness and randomness in aggregate economic behavior. In this article, we will review the evolution of Sims’ Rational Inattention theory over the years and how it has been applied in the field of investments and financial markets.
Early work of Sims in VAR modeling shaped time series econometrics
In his early career, Sims developed the VAR modeling approach for analyzing multivariate time series data in economics. His 1980 paper “Macroeconomics and Reality” was highly influential and helped overturn the dominance of structural econometric modeling in macroeconomics. The VAR model provides a methodology for characterizing the dynamic interrelationships among multiple time series without needing to impose theoretical restrictions. This more atheoretical ‘measurement without theory’ approach allows the data to speak more freely. The flexibility of VAR modeling proved useful for forecasting, structural inference and policy analysis. Sims’ work on VAR modeling shaped the field of time series econometrics and became a core analytical tool in empirical macroeconomics and finance.
Rational Inattention theory formalized the idea of information constraints
Christopher Sims introduced the theory of Rational Inattention in the early 2000s, formalizing the notion that economic agents face informational constraints and cannot observe the state of the economy perfectly. Some key publications that developed this theory include:
– ‘Implications of Rational Inattention’ (2003): Sims’ seminal paper where he first laid out theRational Inattention framework and showed how it could explain sticky prices andother economic rigidities.
– ‘Rational Inattention: Beyond the Linear-Quadratic Case’ (2006): Generalized the RationalInattention model beyond the linear-quadratic Gaussian framework.
– ‘Rational Inattention and Monetary Economics’ (2006): Applied the theory of RationalInattention to model the behavior of central banks.
– ‘Information Theory and Rational Inattention’ (2010 book chapter): Provided a definitive overviewof the Rational Inattention theory, situating it within the broader context of Information Theory.
Rational Inattention used to model investor behavior and asset price dynamics
In recent years, the theory of Rational Inattention has been applied to model investor behavior and asset price dynamics in financial markets. Key papers include:
– ‘Rational Inattention, the Zero Lower Bound, and the Optimal Inflation Target’ (2015): Used Rational Inattention to study the implications of the zero lower bound on nominal interest rates for optimal monetary policy.
– ‘Rational Inattention and the Dynamics of Consumption and Wealth’ (2016): Developed amodel of consumption and saving under Rational Inattention that can match empirical facts on the joint dynamics of income, consumption and wealth.
– ‘Rational Inattention and Informational Rigidities in Choosing Consumption’ (2017): Showed how Rational Inattention can explain stickiness in consumption behavior at the micro level.
– ‘Rational Inattention in Heterogeneous Firms’ (2018): Incorporated Rational Inattention intomodels of producer behavior to explain rigidities in price setting.
Overall, the theory of Rational Inattention provides a micro-founded framework for modeling the informational frictions faced by investors and firms in absor ping and responding to macroeconomic conditions and news. This offers a promising approach for developing behavioral asset pricing models.
Wide range of economic behaviors explained through Rational Inattention
Beyond asset prices and investor behavior, the theory of Rational Inattention has also been applied to explain various economic phenomena:
– Consumption behavior: Rational Inattention leads to stickiness and inertia in consumption.
– Price rigidity: Firms change prices slowly due to costs of acquiring info about demand.
– Policymaking: Central banks face cognitive constraints in tracking the state of the economy.
– Household portfolio choice: Limited attention helps explain low stock market participation.
– Firm dynamics: Suboptimal decisions due to information processing costs affects firm growth.
The beauty of Rational Inattention theory is that it provides a unified framework for understanding economic behavior across a wide range of contexts under information processing constraints.
The theory of Rational Inattention developed by Christopher Sims offers a powerful behaviorally-grounded framework for modeling economic behavior under informational constraints. From its genesis in Sims’ PhD thesis to its applications in macroeconomics, consumption and asset pricing, this theory has evolved to become a core conceptual tool for modern economics and finance.