Imperfect Information, Heterogeneous Demand Shocks, and Inflation Dynamics
Using sector-level survey data for the universe of Japanese firms, we establish the positive co-movement in the firm’s expectations about aggregate and sector-specific demand shocks. We show that a simple model with imperfect information on the current aggregate and sector-specific components of demand explains the positive co-movement of expectations in the data. The model predicts that an increase in the relative volatility of sector-specific demand shocks compared to aggregate demand shocks reduces the sensitivity of inflation to changes in aggregate demand. We test and corroborate the theoretical prediction on Japanese data and find that the observed decrease in the relative volatility of sector-specific demand has played a significant role for the decline in the sensitivity of inflation to movements in aggregate demand from mid-1980s to mid-2000s.
A large class of macroeconomic models builds on the premise that firms set prices to fulfil demand. Several studies show that shocks to demand are heterogeneous and reflect aggregate and sector-specific disturbances.1 Knowing the source that originates the change in demand is important for setting the price consistent with profit maximization. Ball and Mankiw (1995) shows that the price should adjust if the change in demand originates from the aggregate shock, but it should remain unchanged if the change originates from the sector-specific shock. In reality, firms cannot observe the source of any change in demand. They therefore form expectations of aggregate and sector-specific components of demand based on the observed total demand and accrued knowledge from past aggregate and sector-specific shocks. Our analysis establishes important empirical regularities about firms’ expectations on the different aggregate and sector-specific components of total demand, it develops a parsimonious model of imperfect information that explains the co-movements in the expectations, and it studies the implications of empirically-congruous expectations for the sensitivity of inflation to changes in aggregate demand.