Menu Costs, Uncertainty Cycles, and the Propagation of Nominal Shocks

Nominal shocks have long lasting effects on real economic activity, beyond those implied by the average frequency of price adjustment in micro data. This paper develops a price-setting model that explains this gap through the interplay of menu costs and uncertainty about productivity. Uncertainty arises from firms' inability to distinguish between permanent and transitory changes in their idiosyncratic productivity. Upon the arrival of a productivity shock, a firm's uncertainty spikes up and then fades with learning until the arrival of the next shock. These uncertainty cycles, when paired with menu costs, generate recurrent episodes of high frequency of price adjustment followed by episodes of low frequency of adjustment at the firm level. This time variation in the individual adjustment frequency is consistent with empirical patterns, in particular a decreasing hazard rate of adjustment, and it is key to understand the sluggish propagation of nominal shocks