2018 Reports

Strategic Inattention, Inflation Dynamics and the Non-Neutrality of Money

Afrouzi Khosroshahi, Hassan

In countries with low and stable inflation, price setters’ inflation expectations are highly dispersed; especially so when they face fewer competitors. In contrast to the predictions of standard models, realized inflation deviates significantly from price setters’ aggregate infla- tion expectations. Instead, firms’ own-industry inflation expectations are more accurate, and aggregate inflation tracks these expectations closely. This paper poses a new dynamic general equilibrium model of rational inattention with oligopolistic pricing in which these patterns emerge from the optimal choices of firms in information acquisition. A new micro-founded Phillips curve relates aggregate inflation to firms’ expectations about their own competitors’ price changes, and firms optimally forego learning about aggregate variables to focus on their competitors’ beliefs. This incentive is stronger when firms face fewer competitors and non- existent under monopolistic competition. Using firm-level evidence, I calibrate the degree of rational inattention as well as industry concentration and find that, relative to the benchmark of monopolistic competition, the impact response of output (inflation) to a one percent monetary policy shock is 20 basis points larger (smaller) when these strategic incentives are accounted for. Limited competition at the micro-level also increases the half-lives of output and inflation responses to monetary policy shocks by 12% and 15%, respectively.