Date Added: Dec 2010
In this paper, the authors examine the effects of two types of information imperfections, RoBustness (RB) and finite information-processing capacity (called Rational Inattention or RI), on international consumption correlations in an otherwise standard small open economy model. They show that in the presence of capital mobility in financial markets, RB lowers the international consumption correlations by generating heterogeneous responses of consumption to income shocks across countries facing different macroeconomic uncertainty. However, the calibrated RB model cannot explain the observed consumption correlations quantitatively. They then show that introducing RI is capable of matching the behavior of international consumption quantitatively via two channels: the gradual response to income shocks that increases the correlations and the presence of the common noise shocks that reduce the correlations.