Dynamic Inattention, the Phillips Curve, and Forward Guidance

Abstract

We show that rationally inattentive firms are forward-looking in their information acquisition and study the implications of these incentives for inflation dynamics by deriving a new microfounded Phillips curve. The Phillips curve is forward looking and relates current inflation to the forecast errors of firms about future inflation and the growth rate of the output gap in the economy -- a feature that is absent in sticky and noisy information models. Unlike the forward-looking Phillips curves derived under nominal rigidities, we show inflation is not necessarily increasing in expected inflation, and it decreases with the forecast errors of firms about future inflation and output gap growth. We test this Phillips curve using the Survey of Professional Forecasters as a proxy for firms’ expectations and show that forecast errors about future significantly affect current inflation in the direction that is predicted by the model. We apply our findings to examine the effectiveness of forward guidance policies in a general equilibrium model. News about future interest rates affects inflation more if firms are more rationally inattentive or if they discount future profits less. The model also survives the forward guidance puzzle as the initial response of inflation decreases with the horizon of forward guidance.