Behavioral-Attention Phillips Curve: Theory and Evidences From Inflation Surveys

Abstract

Abstract. I derive a theory of endogenous uncertainty and attention choice that can jointly account for two recent phenomena: (i) the flattening Phillips Curve and (ii) “well-anchored” inflation. In particular, I derive a Behavioral Attention Phillips Curve (BAPC) whose slopes on the output gap and inflation expectations decline when inflation is less uncertain. When inflation uncertainty is low, firms find it less costly to misperceive aggregate demand and inflation expectations, thus pay little attention to monetary shocks and change prices less. The dampened price response flattens the Phillips Curve. Inflation becomes more anchored with low uncertainty because costly attention motivates firms to rely more on “rules-of-thumb” such as the 2% inflation target. Using novel measures of inflation uncertainty constructed from surveys of inflation expectation, I show that the new Phillips Curve performs better both in-sample and out-of-sample than the traditional Phillips Curve with constant slope. Particularly, the BAPC does not generate the counterfactual prediction of large disinflation after the 2008-2009 Financial Crisis as does traditional Phillips Curves, resolving the Missing Disinflation Puzzle. I show that multiple equilibria arise with medium volatility due to the complementarity between pricing and attention choices. This gives rise to a novel policy paradox for the Central Bank and makes it hard to raise inflation in a quiet, low-volatility period.