Information Constraints as Micro-foundations for Nominal

Rigidity

Filip MatějkaCERGE-EI,

A joint workplace of Charles University and Academy of Sciences of the Czech Republic

Understanding nominal rigidity is important

Why aren’t most prices perfectly flexible? • Inflation picks up a few months after interest rates are

cut by a central bank

• Decrease in consumption tax often doesn’t translate in immediate decrease of prices

• Input cost hikes do not have rapid effects

Understanding nominal rigidity is important• Keynes’ explanation for monetary policy effects

• Prices affect most economic decisions, etc.

Information Constraints as Micro-foundations for Nominal Rigidity

This paper: • Explanation why prices are rigid

• Prices are rigid because people do not pay full attention to changes in the economy

• Specific implications, mathematical formalization

Sluggishness Standard models of nominal rigidity

• Predict immediate response of GDP, unempl. to nominal shocks

More general friction needed: information (Chris Sims) ..Rational Inattention

Do we really have little info? When investing, choosing a vacation destination,

negotiating a deal…, we should know the exchange rates

If we do not pay attention, we can not react to changes

Yes, I think so… Not even economists pay attention to economic

variables, at least the young ones don’t

More important variables are followed more closely

Enough Hand-waving: Information Theory

Mathematically, knowledge is described as probability distribution

Processing information narrows the distribution

Choosing what to learn is how to narrow the distribution

Economics, Behavioral Insights, Mathematics

Models simulate

1.What information is acquired

2.What is the response

Price responses to shocks

Findings

Competitive industries respond to others’ prices rather than input costs, taxes, etc.

• They can lose a lot by being more expensive

Volatile and competitive industries respond faster

• they always need to pay more attention

Firms respond faster in unusual times

• Hyperinflation, crisis, ..

• Central bank becomes less efficient

Applications Central Banks

• What interest rate adjustment path to adopt

• Transparency is good

Fiscal Policy

• How to stimulate economy the fastest (what industries, what forms)

• Simpler tax codes are beneficial (uniform rates, etc. )

• Birth bonuses(?) vs. subsidies on baby shoes, public transportation, exhibitions, etc.

Optimal regulation

• No caps on taxi prices

Other Applications of Rational Inattention

Sudden changes of behavior, with Chris Sims

• Portfolio reallocation

Optimal number of offered varieties, with Alisdair McKay

• How many different types of jam to offer

• How many pension plans

How much discretion to provide subordinates with

Hayek’s informational efficiency of markets

Thank you.

...for rational (in)attention