Information Frictions and Monetary Policy

Real effects of monetary policy depend crucially on the nature of nominal rigidities. These rigidities are typically modelled as sticky prices with explicit assumptions on either frequency of price adjustments (Calvo-style models) or on the cost of adjustment (menu cost models). However, recent empirical work cast doubts on these workhorses of standard New Keynesian models. This paper discusses another approach to nominal frictions, which is based on the assumption that agents face difficulties processing information. If, for instance, price-setters learn about an interest rate cut with a delay, then their price also responds sluggishly. This rigidity implies positive temporary effects on output and unemployment. We conclude that models based on information frictions can account for several empirical facts other model have difficulties reconciling with, such as sluggish responses of both real and nominal variables, frequent but staggered price changes or a steeper Phillips curve and higher profit losses with more volatile environments. Moreover, rational inattention provides important implications for policy.