Rational Inattention, Random Choice, and Dynamics of Price Adjustment

National Science Foundation, SES-0820438
Principal Investigator: Michael Woodford



This project develops an alternative theory of stochastic discrete choice. Standard econometric models of discrete choice in microeconomic applications, such as transportation economics, account for random individual choices, conditional on measured fundamentals, by assuming random utility. In macroeconomic models of discrete adjustment, the most common source of randomness is assumed randomness in the fixed cost of adjustment.

This research instead pursues the hypothesis that random choice results from imperfect precision in agents' discrimination of the features of the choice that they face, of the kind documented by experimental studies in psychophysics. The precise form of agents' imperfect awareness of their environment is modeled using the hypothesis of "rational inattention" proposed by Sims (1998, 2003, 2006). According to that hypothesis agents have exactly that information which is most valuable to them, given their decision problem, subject to a constraint on the quantity of information that they are able to process. In this, quantity of information is measured as in the information theory of Shannon (1948). Following this approach yields very specific quantitative predictions in which there is only a single free parameter introduced by the hypothesis of inattentiveness, namely a measure of information flow or of the cost of information.

A particular focus is the application of this idea to models of price adjustment. Models with fixed costs of price adjustment ("menu costs") are widely used in attempts to explain data on individual discrete price adjustments. The recent literature has stressed that allowance for endogenous timing of price changes results in substantially different dynamics of adjustment of the general price level than would be predicted by models with exogenous timing of price changes. The latter is subsumed in empirical DSGE models of the monetary transmission mechanism and in analyses of alternative monetary policies. This project reexamines the issue under the assumption that decisions whether to review one's existing price are made with imprecise awareness of current market conditions. Preliminary results suggest that the Calvo (1983) model of staggered price setting can provide quite an accurate approximation to equilibrium dynamics under most circumstances when there is a moderate cost of attention between full reviews of pricing policy. However, the predicted outcome is quite different from that of the Calvo model under certain circumstances, such under unusually large shock.

By contributing to the understanding of the dynamics of price adjustment -- a key issue in macroeconometric models of the monetary transmission mechanism used for policy simulations -- the project aims to improve the accuracy of monetary policy analysis inside and outside central banking institutions. Findings on the implications of alternative models of price adjustment for the welfare consequences of inflation stabilization should be of particular importance to the improvement of public policy.



Working Papers and Publications

Marc P. Giannoni & Michael Woodford, 2010. "Optimal Target Criteria for Stabilization Policy," NBER Working Papers 15757, National Bureau of Economic Research, Inc.
NBER Working Paper 15757: http://www.nber.org/papers/w15757

Michael Woodford, 2010. "Simple Analytics of the Government Expenditure Multiplier," Discussion Papers 0910-09, Columbia University, Department of Economics.
NBER Working Paper 15714: http://www.nber.org/papers/w15714

Michael Woodford, 2010. "Comment on ‘Two Monetary Tools: Interest Rates and Haircuts’" NBER Chapters, NBER Macroconomics Annual 2010, Volume 25
National Bureau of Economic Research, Inc.
Full Text: http://www.columbia.edu/~mw2230/MA2010_final.pdf

Michael Woodford, 2010. "Optimal Monetary Stabilization Policy," Discussion Papers 0910-18, Columbia University, Department of Economics.
NBER Working Paper 16095: http://www.nber.org/papers/w16095

Michael Woodford, 2010. "Robustly Optimal Monetary Policy with Near-Rational Expectations." American Economic Review, 100(1): 274–303.
NBER Working Paper 11896: http://www.nber.org/papers/w11896

Michael Woodford, 2008. "Information-Constrained State-Dependent Pricing," NBER Working Papers 14620, National Bureau of Economic Research, Inc.
NBER Working Paper 14620: http://www.nber.org/papers/w14620