Rational Inattention-driven dispersion with volatility shocks

Abstract

This paper studies price-setting decisions under Rational Inattention. Prices are set by tracking an unobserved target whose distribution is also unknown. The distribution of the target can change over time, depending on persistent and unanticipated volatility shocks that hits the economy. Information acquisition is dynamic and fully flexible since, given information acquired in the past, owners choose the amount of information to collect as well as how they want to learn about both the outcome and its distribution. I show that allowing for imperfect information as the unique source of rigidity, the model is able to simultaneously reconcile several stylized facts from the microeconomic evidence on price-setting, both at the cross-sectional and time series levels. The model is consistent with countercyclical price dispersion and with the presence of a positive correlation between dispersion and frequency of price changes, two features supported by the data. Dynamic imperfect information endogenously generates persistence in beliefs, which is crucial to replicate the dynamic empirical behavior of prices, without further assumptions about price-rigidities.