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PRICE-SETTING WITH UNOBSERVABLE ELASTICITIES OF DEMAND: THE BUSINESS-CYCLE EFFECTS OF HETEROGENEOUS EXPECTATIONS

Published online by Cambridge University Press:  06 July 2015

Christian Jensen
Christian Jensen*
Affiliation:
University of South Carolina
*
Address correspondence to: Christian Jensen, Department of Economics, University of South Carolina, 1014 Greene Street, Columbia, SC 29208, USA; e-mail: [email protected].
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Abstract

In a dynamic stochastic general equilibrium model with monopolistic competition and flexible prices, we assume that producers must estimate their demand elasticities, which leads to heterogeneous expectations because of idiosyncratic shocks. I argue that these expectations shape firms' perceptions of relative prices, market shares, and individual demand elasticities, thereby distorting their price-setting and production. This model concludes that discarding the conventional assumption of known and exogenous demand elasticity generates business cycle fluctuations indistinguishable from those produced by traditional productivity shocks.

Keywords

Price-SettingHeterogeneous ExpectationsMisallocationProductivity
Type
Articles
Information
Macroeconomic Dynamics , Volume 20 , Issue 4 , June 2016 , pp. 1101 - 1125
Copyright
Copyright © Cambridge University Press 2015 

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