Abstract

We study how bounded rationality coevolves with the business cycle. We introduce a business-cycle model in which firms face a cognitive cost of making precise decisions. Theoretically, we characterize equilibrium with non-parametric, statedependent stochastic choice. Firms have greater incentives to pay attention in downturns because they are owned by risk-averse households. Correspondingly, the model generates counter-cyclical attention, pro-cyclical mistakes, and an endogenous attention wedge that depresses aggregate productivity when attention is low. Empirically, we test the model’s predictions using novel measures of firms’ mistakes and attention. Quantitatively, attention cycles generate significant stochastic volatility of output growth and shock propagation asymmetries.