Incomplete information, higher-order beliefs and price inertia

Abstract

This paper investigates how incomplete information impacts the response of prices to nominal shocks. Our baseline model is a variant of the Calvo model in which firms observe the underlying nominal shocks with noise. In this model, the response of prices is pinned down by three parameters: the precision of available information about the nominal shock; the frequency of price adjustment; and the degree of strategic complementarity in pricing decisions. This result synthesizes the broader lessons of the pertinent literature. We next highlight that this synthesis provides only a partial view of the role of incomplete information. In general, the precision of information does not pin down the response of higher-order beliefs. Therefore, one cannot quantify the degree of price inertia without additional information about the dynamics of higherorder beliefs, or the agents’ forecasts of inflation. We highlight the distinct role of higher-order beliefs with three extensions of our baseline model, all of which break the tight connection between the precision of information and higher-order beliefs featured in previous work.