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

Christian Jensen ()

Macroeconomic Dynamics, 2016, vol. 20, issue 4, 1101-1125

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.

Date: 2016
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