Discussion Paper Series 2019-E-15

Imperfect Information, Shock Heterogeneity, and Inflation Dynamics

Tatsushi Okuda, Tomohiro Tsuruga, Francesco Zanetti

We establish important empirical regularities on firms' expectations about aggregate and idiosyncratic components of sectoral demand using industry-level survey data for the universe of Japanese firms. Expectations about the idiosyncratic component of demand differ across sectors, and they positively co-move with those about aggregate component. To study the implications for firms' price setting, we develop a theoretical framework that captures systematic features in firms' expectation formation based on inference of different shocks from a common signal--a chief modelling approach to imperfect information. We show that the sensitivity of inflation to changes in demand decreases with the volatility of idiosyncratic component of demand that proxies the degree of shock heterogeneity. We use principal component analysis on Japanese sectoral-level data to estimate the degree of shock heterogeneity, and we establish that the observed increase in shock heterogeneity plays a significant role for the reduced sensitivity of inflation to movements in real activity since the late 1990s.

Keywords: Imperfect information; Shock heterogeneity; Inflation dynamics

Views expressed in the paper are those of the authors and do not necessarily reflect those of the Bank of Japan or Institute for Monetary and Economic Studies.

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