Sticky Prices, Sticky Information or Rational Inattention? Evaluating Microfoundations

This paper evaluates competing sets of microfoundations on firms’ price-setting behaviour widely used in monetary economics. The contribution of this project is twofold. The first contribution is to use as inflation driver a relevant measure of marginal cost from wage microdata. To that end, I calculate the User Cost of Labor as in Basu and House (2016) for the first time in a different dataset, and confirm their findings. The second contribution is the micro-evidence on the three leading price-setting theories used in macro models. I show compelling evidence that Calvo’s (1983) sticky price model fits well for good prices; service prices favour Mankiw and Reis’ (2002) sticky information model; and that there is little empirical support for Mackowiak and Wiederholt’s (2009) rational inattention model. These results suggest that models with a single price-setting decision process may be insufficient to adequately capture the monetary transmission mechanism. ∗I would like to thank Huw Dixon for his useful comments. This paper has greatly benefited from comments received at the International-Macro Workshop at Warwick. Errors are all mine. Department of Economics, University of Warwick, Coventry CV4 7AL, UK. E-mail: [email protected]