Paralyzed by Fear : Rigid and Discrete Pricing under Demand Uncertainty

We propose a new theory of price rigidity based on firms' Knightian uncertainty about their competitive environment. This uncertainty has two key implications. First, firms learn about the shape of their demand function from past observations of quantities sold. This learning gives rise to kinks in the expected profit function at previously observed prices, making those prices both sticky and more likely to reoccur. Second, uncertainty about the relationship between aggregate and industry-level inflation ensures nominal rigidity. We prove the main insights analytically and also quantify the effects of our mechanism. Our estimated quantitative model is consistent with a wide range of micro-level pricing facts that are typically challenging to match jointly, and implies significant monetary non-neutrality