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The Response of Prices to Technology and Monetary Policy Shocks under Rational Inattention

  • Luigi Paciello

    (Northwestern University and EIEF)

The speed of inflation adjustment to aggregate technology shocks is substantially larger than to monetary policy shocks. Prices adjust very quickly to technology shocks, while they only respond sluggishly to monetary policy shocks. This evidence is hard to reconcile with existing models of stickiness in prices. I show that the difference in the speed of price adjustment to the two types of shocks arises naturally in a model where price setting firms optimally decide what to pay attention to, subject to a constraint on information flows. In my model, firms pay more attention to technology shocks than to monetary policy shocks when the former affects profits more than the latter. Furthermore, strategic complementarities in price setting generate complementarities in the optimal allocation of attention. Therefore, each firm has an incentive to acquire more information on the variables that the other firms are, on average, more informed about. These complementarities induce a powerful amplification mechanism of the difference in the speed with which prices respond to technology shocks and to monetary policy shocks.

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Paper provided by Einaudi Institute for Economics and Finance (EIEF) in its series EIEF Working Papers Series with number 0816.

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Length: 56 pages
Date of creation: 2008
Date of revision: Nov 2007
Handle: RePEc:eie:wpaper:0816
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