Relative Prices, Price Level and Inflation: Effects of Asymmetric and Sticky Adjustment

Abstract

The paper examines how relative price shocks can affect the price level and then inflation. Using Indian data, it is observed that: (1) Price increases exceed price decreases. Aggregate inflation depends on the distribution of relative price changes — inflation rises when the distribution is skewed to the right; (2) Such distribution-based measures of supply shocks perform better than the traditional measures, such as prices of energy and food. They moderate the price puzzle, whereby a rise in policy rates increases inflation, are significant in estimations of New Keynesian aggregate supply, and show the Indian aggregate supply curve to be flat, but subject to shifts; (3) An average Indian firm changes prices about once in a year. The estimated Calvo parameter implies that half of the Indian firms reset their prices in any period, while 66% of firms are forward looking in their price setting. These estimated real and nominal price rigidities imply policy needs to anchor inflationary expectations in response to supply shocks, but policy responses must be moderate.