Information Constraints as Micro-foundations for Nominal Rigidity Filip Matějka CERGE-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