Relative Goods' Prices and Pure Inflation

40 Pages Posted: 6 Jun 2008

See all articles by Ricardo Reis

Ricardo Reis

London School of Economics & Political Science (LSE); National Bureau of Economic Research (NBER); Centre for Economic Policy Research (CEPR)

Mark W. Watson

Princeton University - Woodrow Wilson School of Public and International Affairs; National Bureau of Economic Research (NBER)

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Abstract

This paper uses a dynamic factor model for the quarterly changes in consumption goods' prices to separate them into three components: idiosyncratic relative-price changes, aggregate relative-price changes, and changes in the unit of account. The model identifies a measure of pure inflation: the common component in goods' inflation rates that has an equiproportional effect on all prices and is uncorrelated with relative price changes at all dates. The estimates of pure inflation and of the aggregate relative-price components allow us to re-examine three classic macro-correlations. First, we find that pure inflation accounts for 15-20% of the variability in overall inflation, so that most changes in inflation are associated with changes in goods'relative prices. Second, we find that the Phillips correlation between inflation and measures of real activity essentially disappears once we control for goods' relative-price changes. Third, we find that, at business-cycle frequencies, the correlation between inflation and money is close to zero, while the correlation with nominal interest rates is around 0.5, confirming previous findings on the link between monetary policy and inflation.

Keywords: Dynamic Factor Models, Inflation, Phillips relation, Relative prices

JEL Classification: C32, C43, E31

Suggested Citation

Reis, Ricardo A.M.R. and Watson, Mark W., Relative Goods' Prices and Pure Inflation. CEPR Discussion Paper No. DP6593. Available at SSRN: https://ssrn.com/abstract=1140522

Ricardo A.M.R. Reis (Contact Author)

London School of Economics & Political Science (LSE) ( email )

Houghton Street
London, WC2A 2AE
United Kingdom

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

Centre for Economic Policy Research (CEPR)

London
United Kingdom

Mark W. Watson

Princeton University - Woodrow Wilson School of Public and International Affairs ( email )

Princeton University
Princeton, NJ 08544-1021
United States

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

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