Discussion Paper Details

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Title: Spending Allocation under Nominal Uncertainty: A Model of Effective Price Rigidity

Author(s): Gaetano Gaballo and Luigi Paciello

Publication Date: May 2021


Programme Area(s): Monetary Economics and Fluctuations

Abstract: This paper reverses the typical firm-centered view on the source of co-movement of output and inflation, assuming instead that consumers face greater frictions than firms in responding to relative price changes. We model consumers as uncertain whether the fluctuations in flexible prices posted by local monopolists are aggregate or idiosyncratic in origin. An aggregate increase in local prices may then drive correlated forecasting mistakes, coordinating households' decisions to reallocate spending from local monopolistic to a competitive market at the cost of individual-specific shopping effort. We obtain three theoretical results and empirically test a tight prediction of our model. First, a distortion in competition arises, in that firms respond strategically to households' confusion over the source of posted price volatility, resulting in higher markups. Second, in the more realistic case of households being relatively less informed than firms, our new channel of frictional shopping features positive output-inflation co-movement, which is negative otherwise. Third, we show a new rationale for policies to reduce uncertainty, such as nominal stabilization or communication, counting on an attenuation of the competitive distortion. Finally, we use retailer scanner data to validate a distinctive prediction of the model, namely that the difference between posted and effective price inflation co-moves with an inflationary shock.

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Bibliographic Reference

Gaballo, G and Paciello, L. 2021. 'Spending Allocation under Nominal Uncertainty: A Model of Effective Price Rigidity'. London, Centre for Economic Policy Research.