Information Frictions, Nominal Shocks, and the Role of Inventories in Price-Setting Decisions

Models with information frictions display output and inflation dynamics that are consistent with the empirical evidence. However, an assumption in the existing literature is that pricing managers do not interact with production managers within firms. If this assumption were relaxed, nominal shocks would not have real effects on the economy. In this paper, I present a model with information frictions, output inventories, and perfect communication within firms where nominal shocks have real effects. In this model, final goods firms observe aggregate variables with one period lag but observe their nominal input price and demand at all times. Hence, firms will accumulate inventories as long as they think that they are facing a low input price (cost-smoothing role of inventories). After a contractionary nominal shock, the nominal input price goes down, and firms accumulate inventories because the probability of a good productivity shock is positive. This prevents firms' prices from decreasing, which distorts relative prices and makes current profits and households' income go down. As a consequence, the aggregate demand falls. I found that nominal shocks have a delayed effect on output, and that the responses to nominal shocks are significant, persistent, and hump-shaped. Output, capital, and total investment decrease by 0.5%, 1.8% and 3.4%, respectively, after a 1% increase in the nominal interest rate. Moreover, the peak of most of the responses is two quarters after the shock. When the model is simulated, it displays moments that are closer to the data than a comparable model with perfect information.