Information Frictions, Monetary Policy, and the Paradox of Price Flexibility

Abstract

The introduction of digital price tags and online shopping may facilitate price adjustments and reduce the degree of nominal rigidity in the economy. Is this welfare-improving? We address this question in a multi-sector New Keynesian model with information frictions and dispersed beliefs. Increased price flexibility may deteriorate welfare through the dispersed beliefs channel and the amplified spillover effects. The dispersed beliefs create a novel channel through which the welfare cost of inflation in a sector increases in price flexibility, altering the optimal inflation target policy. A monetary policy that stabilizes the optimal inflation index mitigates the paradox.

Keywords: Dispersed beliefs, Information Frictions, Spillover Effects, Monetary Policy, Inflation Target, Paradox of Price Flexibility

JEL Classification: E31, E32, E52, E58