Price Dispersion, Private Uncertainty, and Endogenous Nominal Rigidities

This paper shows that when agents learn from prices, large private uncertainty may result from a small amount of heterogeneity. As in a Phelps-Lucas island model, final producers look at the prices of their local inputs to infer aggregate conditions. However, market linkages between islands make the informativeness of local prices endogenous to general equilibrium relations. In this context, I show that a vanishingly small heterogeneity in local conditions is enough to generate an equilibrium in which prices are rigid to aggregate shocks and transmit only partial information. I use this insight as a microfoundation for price rigidity in an otherwise frictionless monetary model and show that even a tiny amount of dispersion in fundamentals can lead to large non-neutrality of money.