Really, Really Rational Inattention: Or, How I Learned to Stop Worrying and Love Sticky Prices∗

We develop a general equilibrium framework where sellers post nominal prices that may not respond to changes in the aggregate price level – but this is an outcome, and not an assumption. Money is used as a medium of exchange, and hence it is natural that prices are posted in dollars. Due to search frictions, there is a nondegenerate price distribution, where low price sellers earn less per unit but make it up on the volume. When the money supply increases, it is not necessary for all sellers to raise prices, as long as the real distribution is invariant. Profit maximization is consistent with sellers resetting prices infrequently, or being inattentive, even though we allow them to change for free whenever they like. The model has many testable predictions. We get closed-form solutions for the price density, and determine how it depends on inflation. Also, when sellers change they need not all set the same price – a new posting may be high, low, or in between, and there can be price reductions, despite inflation. Also, the frequency of price changes increases with inflation, and sellers who have not changed for a long time are more likely to reset prices, especially during high inflation. Although in a sense we provide microfoundations for a key feature of Keynesian economics, the policy implications are very different: our theory implies classical neutrality (inflation matters but the price level does not). Thus, although individual prices appear to be, and in a real sense are, sticky, shocks to money have no real effects.