Information frictions, monetary policy, and the paradox of price flexibility

• Published in: Journal of monetary economics Vol. 120; pp. 70 - 82
• Main Authors: Ou, Shengliang, Zhang, Donghai, Zhang, Renbin
• Format: Journal Article
• Language: English
• Published: Elsevier B.V 01-05-2021
• Subjects: Information frictions; Monetary policy; New keynesian model; Paradox of price flexibility; Spillover effects; E31; Paradox of price flexibility; E52; E32; Spillover effects; Information frictions; Monetary policy; New keynesian model; E58
• ISSN: 0304-3932; 1873-1295
• DOI: 10.1016/j.jmoneco.2021.03.005

•Reduction in nominal rigidity does not necessarily improve welfare.•Increased price flexibility may decrease welfare through the dispersed belief channel.•Increased price flexibility may decrease welfare through the amplified spillover effects.•Dispersed beliefs alter the optimal inflation index stabilization policy.•A monetary policy that stabilizes the optimal inflation index mitigates the paradox.
The introduction of digital price tags and e-commerce facilitates the implementation of price adjustments and thereby diminishes the degree of nominal rigidity in an economy. Is this phenomenon welfare-improving? We address this question using a multi-sector New Keynesian model with information frictions and dispersed beliefs. Increased price flexibility may decrease welfare through the dispersed belief channel and the amplified spillover effects. Dispersed beliefs create a novel channel through which the welfare cost of inflation in a sector increases with price flexibility, altering the optimal inflation index stabilization policy. A monetary policy that stabilizes the optimal inflation index mitigates this paradox.