Incomplete Information and Nominal Rigidities in a Price-Setting Model

Can informational frictions serve to amplify the real effects generated by other sources of nominal rigidity? We attempt to answer this question by augmenting an incomplete information model by adding different forms of nominal stickiness. We investigate the implications of different assumptions about price-setting behavior (e.g. time-dependent versus state-dependent pricing) as well as about the stochastic processes governing the evolution of aggregate and firm-specific shocks (e.g. random walks versus completely transitory). With flexible prices, Hellwig and Venkateswaran (2009) show that the presence of large and persistent idiosyncratic shocks makes the aggregate price level very responsive to small aggregate nominal shocks in the short-to-medium term. We find that nominal frictions not only serve to reduce the amount of adjustment in the short run, but also enhance the effects of informational frictions over the medium and longer run.