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The Elusive Costs of Inflation: Price Dispersion during the U.S. Great Inflation

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  • Emi Nakamura
  • Jón Steinsson
  • Patrick Sun
  • Daniel Villar

Abstract

A key policy question is: how high an inflation rate should central banks target? This depends crucially on the costs of inflation. An important concern is that high inflation will lead to inefficient price dispersion. Workhorse New Keynesian models imply that this cost of inflation is very large. An increase in steady-state inflation from 0% to 10% yields a welfare loss that is an order of magnitude greater than the welfare loss from business cycle fluctuations in output in these models. We assess this prediction empirically using a new data set on price behavior during the Great Inflation of the late 1970s and early 1980s in the United States. If price dispersion increases rapidly with inflation, we should see the absolute size of price changes increasing with inflation: price changes should become larger as prices drift further from their optimal level at higher inflation rates. We find no evidence that the absolute size of price changes rose during the Great Inflation. This suggests that the standard New Keynesian analysis of the welfare costs of inflation is wrong and its implications for the optimal inflation rate need to be reassessed. We also find that (nonsale) prices have not become more flexible over the past 40 years.

Suggested Citation

  • Emi Nakamura & Jón Steinsson & Patrick Sun & Daniel Villar, 2018. "The Elusive Costs of Inflation: Price Dispersion during the U.S. Great Inflation," The Quarterly Journal of Economics, Oxford University Press, vol. 133(4), pages 1933-1980.
  • Handle: RePEc:oup:qjecon:v:133:y:2018:i:4:p:1933-1980.
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    File URL: http://hdl.handle.net/10.1093/qje/qjy017
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    References listed on IDEAS

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    1. Bernardo Guimaraes & Kevin D. Sheedy, 2011. "Sales and Monetary Policy," American Economic Review, American Economic Association, vol. 101(2), pages 844-876, April.
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    7. Etienne Gagnon, 2007. "Price setting during low and high inflation: evidence from Mexico," International Finance Discussion Papers 896, Board of Governors of the Federal Reserve System (U.S.), revised 2007.
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    9. Viacheslav Sheremirov, 2015. "Price dispersion and inflation: new facts and theoretical implications," Working Papers 15-10, Federal Reserve Bank of Boston, revised 01 Jul 2015.
    10. Etienne Gagnon, 2009. "Price Setting during Low and High Inflation: Evidence from Mexico," The Quarterly Journal of Economics, Oxford University Press, vol. 124(3), pages 1221-1263.
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    JEL classification:

    • E31 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Price Level; Inflation; Deflation
    • E50 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - General

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