This paper presents a model in which price setting firms decide what to pay attention to, subject to a constraint on information flow. When idiosyncratic conditions are more variable or more important than aggregate conditions, firms pay more attention to idiosyncratic conditions than to aggregate conditions. When we calibrate the model to match the large average absolute size of price changes observed in micro data, prices react fast and by large amounts to idiosyncratic shocks, but only slowly and by small amounts to nominal shocks. Nominal shocks have strong and persistent real effects. An optimizing trader will process those prices of most importance to his decision problem most frequently and carefully, those of less importance less so, and most prices not at all. Of the many sources of risk of importance to him, the business cycle and aggregate behavior generally is, for most agents, of no special importance, and there is no reason for traders to specialize their own information systems for diagnosing general movements correctly. – Robert E. Lucas (1977, 21) JEL Classification: D21, D83, E31, E52

Keywords: Coordination of monetary policy and fiscal policy, policy regime switch, currency crisis, speculative attack, fiscal theory of the price level. * I thank for comments

Optimal Sticky priceS under ratiOnal inattentiOnWO r k i n g pa p e r S e r i e S n O 1 0 0 9 / F e b r ua ry 2 0 0 9 WO R K I N G PA PE R S E R I E S N O 10 0 9 / F E B R UA RY 20 0 9This paper can be downloaded without charge from http://www.ecb.europa.eu or from the Social Science Research Network electronic library at http://ssrn.com/abstract_id=1333608. Abstract 4 Non-technical summary 5

We use a statistical model to estimate impulse responses of sectoral price indices to aggregate shocks and to sector-specific shocks. In the median sector, 100 percent of the long-run response of the sectoral price index to a sector-specific shock occurs in the month of the shock. The Calvo model and the sticky-information model match this finding only under extreme assumptions concerning the profit-maximizing price. By contrast, the rational inattention model matches this finding without an extreme assumption concerning the profit-maximizing price. Furthermore, we find little variation across sectors in the speed of response of sectoral price indices to sector-specific shocks. The rational inattention model matches this finding, while the Calvo model predicts far too much cross-sectional variation in the speed of response to sector-specific shocks.

4Non-technical summary 5