Setting the right prices for the wrong reasons

Nominal price adjustment is studied in an environment with firm-specific and aggregate shocks to economic fundamentals and incomplete, dispersed information. Firms update their expectations about fundamentals based on their own cash flows (revenues and wages). We show that in a model with realistic levels of product-level price dispersion, the firms’ inference about aggregate shocks is very gradual, yet in the aggregate prices adjust rapidly in response to aggregate nominal shocks. When an aggregate shock occurs, firms mistakenly attribute it to firm-specific shocks, but adjust prices nevertheless, since the exact nature of the shock matters little for their optimal pricing decision.