Incomplete information, higher-order beliefs and price inertia

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