Incomplete Information, Higher Order Beliefs, and Price Inertia

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 mode, 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 higher-order beliefs, or the agents’ forecast 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