How Planning Horizons Turn into Inflation Uncertainty

This chapter follows the selected planning horizon into the inflation equation and asks how a private decision about analytical effort can make aggregate inflation more or less sensitive to shocks. The focus is the feedback from a large or persistent disturbance to a longer horizon, from that horizon to shock loadings, and from those loadings to one-quarter-ahead uncertainty. The quantitative comparison also makes a necessary judgment possible: the model captures an important relationship, but it does not account for all measured inflation risk.

A longer horizon changes the way shocks enter inflation

A firm’s horizon affects more than the sophistication of its internal reasoning. In the model, it changes the coefficients through which current demand and supply disturbances affect realized inflation. The inflation equation contains three broad pieces: a demand disturbance, a supply or markup disturbance, and the firm’s trend-inflation belief. Each disturbance is multiplied by a loading that depends on the selected horizon.

Those loadings rise as the horizon lengthens. The reason is straightforward. A firm that plans farther ahead incorporates more of the persistent consequences of a current disturbance into its reset price. If demand remains elevated or a supply disturbance continues to affect costs, a deeper plan gives those future effects more influence over today’s price. A short plan relies more heavily on the continuation value, which summarizes what lies beyond the explicit window.

The result is not that a longer horizon makes the firm more responsive to every conceivable change in the same way. It makes the firm’s price more sensitive to the demand and supply processes specified in the model. The amount of sensitivity depends on their persistence. A highly persistent disturbance continues to matter at longer horizons; a quickly fading disturbance contributes less as the firm looks farther ahead. Planning distance therefore magnifies the part of a shock that remains economically relevant over the periods covered by the price decision.

At the same time, the trend component receives less relative weight as the horizon grows. A firm planning only a short distance uses its learned continuation value to summarize more of the future, so that reference has a larger role in the current price. A firm that explicitly evaluates more future contingencies needs less of that summary for the periods it has brought inside the window. The horizon thus changes the balance between current shocks and longer-run beliefs rather than simply adding a general measure of “attention.”

This creates the aggregate feedback. A large or persistent shock can raise the benefit of extending the planning horizon. If many price-setting decisions become more forward-looking in response, their prices load more strongly on the shock’s continuing effects. Inflation then becomes more sensitive to the same underlying disturbance. The mechanism is endogenous because the change in sensitivity comes from the firms’ state-dependent horizon choice, not from an exogenous change in the variance of the shocks.

Learning adds a slower loop. After observing realized inflation and the state in which the price decision was made, the firm updates its continuation value by averaging prior beliefs with the value associated with the latest experience.