Reconsidering the Relationship Between Inflation and Relative Price Variability

Abstract:     
The relationship between inflation and relative price variability (RPV) is widely believed to be positive and stable. Using disaggregated CPI data for the U.S. and Japan, however, this study finds that the relationship is neither linear nor stable over time. The overall relationship is approximately U-shaped and symmetric around a certain threshold: a positive correlation on one side but a trade-off relation on the other. More importantly, the relationship is by no means stable over time but varies significantly in a way that coincides with regime changes of inflation or monetary policy. It was positive in the high inflation environment of the 1970s and the early 1980s as often reported by numerous earlier studies, but changes to U-shape after the great moderation period under a low and stable inflation environment. The results are robust to the use of core inflation that precludes the traditionally volatile prices of food and energy. This paper then presents a simple version of the Calvo-type sticky price model to describe the observed empirical characteristics within a setting of sectoral heterogeneity. According to my simulation results, the nature of the relationship hinges upon the degree of price rigidity such that it is close to U-shape if firms adjust prices more slowly, whereas the U-shape disappears when firms adjust prices more frequently.

Number of Pages in PDF File: 26

Keywords: Inflation, Relative price variability (RPV), Time-varying behavior, U-shape, Calvo model, Sectoral heterogeneity, Degree of price rigidity, Monetary policy.

JEL Classification: E30, E31, E52

working papers series