Spending Allocation Under Nominal Uncertainty: A Model of Effective Price Rigidity

Abstract How do swings in inflation affect shopping behavior? We build on the idea that households’ price hunting intensifies with surprise inflation. In our model, households observe only local monopolists’ prices and must exert effort to see other sellers’ prices to eventually buy from them. This friction leads households to doubt that local price changes are idiosyncratic in nature, even when all prices change uniformly in response to a nominal aggregate shock. In such a case, households overestimate the benefits of exerting effort, reallocating more spending toward lower markup sellers. We show that, through this channel, output can expand significantly with surprise inflation, despite flexible shop pricing and acyclical posted markups. Using US retailer scanner data, we validate our model’s distinctive prediction that inflation measured over paid prices moves more slowly than inflation measured over posted prices, both unconditionally and in response to monetary policy shocks.