FEDS Paper: Inattentive Price Setting and Inflation Under Fiscal Policy Uncertainty

Oliver Pfäuti and Edson Wu

How do high public debt and fiscal uncertainty interact to shape inflation? We develop a model in which firms face uncertainty about both marginal costs and fiscal policy and choose how much information to acquire before setting prices. Higher debt raises steady-state taxes, affecting attention through two opposing forces. While these taxes reduce the profit stakes of mispricing, they make desired prices more sensitive to tax fluctuations, increasing the value of information. The interaction generates a U-shaped relationship between public debt and attention, and therefore between debt and inflation volatility. Using euro-area firm-level expectations data, we document that the passthrough of expected input-cost growth into expected selling-price growth rises systematically with a country's debt-to-GDP ratio, consistent with the model. In the calibrated general-equilibrium model, an increase in debt from 100% to 175% of GDP raises inflation volatility by about 20%, mainly because firms reallocate attention toward fiscal shocks.