Working Paper: NBER ID: w22490
Authors: Cosmin L. Ilut; Rosen Valchev; Nicolas Vincent
Abstract: We propose a new theory of price rigidity based on firms’ Knightian uncertainty about their competitive environment. This uncertainty has two key implications. First, firms learn about the shape of their demand function from past observations of quantities sold. This learning gives rise to kinks in the expected profit function at previously observed prices, making those prices both sticky and more likely to reoccur. Second, uncertainty about the relationship between aggregate and industry-level inflation generates nominal rigidity. We prove the main insights analytically and quantify the effects of our mechanism. Our estimated quantitative model is consistent with a wide range of micro-level pricing facts that are typically challenging to match jointly. It also implies significantly more persistent monetary non-neutrality than in standard models, allowing it to generate large real effects from nominal shocks.
Keywords: price rigidity; demand uncertainty; Knightian uncertainty; monetary non-neutrality
JEL Codes: C1; D8; E3; L11
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Knightian uncertainty about demand (D89) | price rigidity (D41) |
| learning from past sales data (C45) | kinks in expected profit functions (D22) |
| kinks in expected profit functions (D22) | price stickiness (L11) |
| uncertainty about aggregate inflation and industry-level inflation (E31) | nominal rigidity (D10) |
| nominal rigidity (D10) | significant monetary non-neutrality (E49) |