Monetary Shocks in Models with Inattentive Producers

We study models where prices respond slowly to shocks because firms are rationally inattentive. Producers must pay a cost to observe the determinants of the current profit maximizing price, and hence observe them infrequently. To generate large real effects of monetary shocks in such a model the time between observations must be long and/or highly volatile. Previous work on rational inattentiveness has allowed for observation intervals that are either constant-but-long (e.g. Caballero, 1989 or Reis, 2006) or volatile-but-short (e.g. Reis’s, 2006 example where observation costs are negligible), but not both. In these models, the real effects of monetary policy are small for realistic values of the duration between observations. We show that non-negligible observation costs produce both of these effects: intervals between observations are infrequent and volatile. This generates large real effects of monetary policy for realistic values of the average time between observations.