Rational Inattention-driven dispersion over the business cycle

This paper develops a model in which firms acquire costly information to make pricing decisions. Prices are set by tracking an unobserved target whose volatility depends on a persistent state of the economy. Firms are Rationally Inattentive since they face different information processing costs when learning the target. By embedding heterogeneous time-invariant information costs in this persistent volatility setting, I show that the model endogenously generates countercyclical dispersion in price changes, as documented by re- cent empirical findings. Costly information generates a delay in the rate at which firms’ recognize any change of state, leading to different pricing decisions through the transition. Endogenous information and heterogeneous costs alone are enough to replicate the empirical time-varying evolution of the dispersion of price changes, as well as the positive co-movement between the dispersion and frequency of price changes.