Working Paper: NBER ID: w14620
Authors: Michael Woodford
Abstract: I present a generalization of the standard (full-information) model of state- dependent pricing in which decisions about when to review a firm's existing price must be made on the basis of imprecise awareness of current market conditions. The imperfect information is endogenized using a variant of the theory of "rational inattention" proposed by Sims (1998, 2003, 2006). This results in a one-parameter family of models, indexed by the cost of information, which nests both the standard state-dependent pricing model and the Calvo model of price adjustment as limiting cases (corresponding to a zero information cost and an unboundedly large information cost respectively). For intermediate levels of the information cost, the model is equivalent to a "generalized Ss model" with a continuous \\adjustment hazard" of the kind proposed by Caballero and Engel (1993a, 1993b), but provides an economic motivation for the hazard function and very specific predictions about its form. For high enough levels of the information cost, the Calvo model of price-setting is found to be a reasonable approximation to the exact equilibrium dynamics, except in the case of (infrequent) large shocks. When the model is calibrated to match the frequency and size distribution of price changes observed in microeconomic data sets, prices are found to be much less flexible than in a full-information state-dependent pricing model, and only about 20 percent more flexible than under a Calvo model with the same average frequency of price adjustment.
Keywords: State-Dependent Pricing; Information Constraints; Monetary Policy
JEL Codes: E31
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| cost of information (D83) | flexibility of prices (P22) |
| cost of information (D83) | timing of price reviews (L11) |
| timing of price reviews (L11) | overall price adjustment dynamics (E30) |
| cost of information (D83) | price adjustment dynamics (E31) |
| large shocks (E32) | inaccuracy of Calvo model (E19) |