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Inflation Distorts Relative Prices: Theory and Evidence

Author

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  • Klaus Adam
  • Andrey Alexandrov
  • Henning Weber

Abstract

We empirically identify the effect of inflation on relative price distortions, using a novel identification approach derived from sticky price theories with time or state-dependent adjustment frictions. Our approach can be directly applied to micro price data, does not rely on estimating the gap between actual and flexible prices, and only assumes stationarity of unobserved shocks. Using the micro price data underlying the U.K. CPI, we document that suboptimally high (or low) inflation is associated with distortions in relative prices. At the level of individual products, the marginal effect of inflation on relative price distortions is highly statistically significant and aligns well with theoretical predictions. Cross-sectional price dispersion turns out to be predominantly driven by movements in the dispersion of flexible prices and thus fails to comove with inflation over time. In contrast, cross-sectional price distortions are found to increase with aggregate inflation.

Suggested Citation

  • Klaus Adam & Andrey Alexandrov & Henning Weber, 2023. "Inflation Distorts Relative Prices: Theory and Evidence," CRC TR 224 Discussion Paper Series crctr224_2023_406v2, University of Bonn and University of Mannheim, Germany, revised May 2024.
    • Handle: RePEc:bon:boncrc:crctr224_2023_406v2
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    References listed on IDEAS

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    1. Taylor, John B, 1979. "Staggered Wage Setting in a Macro Model," American Economic Review, American Economic Association, vol. 69(2), pages 108-113, May.
    2. Fernando Alvarez & Francesco Lippi & Aleksei Oskolkov, 2022. "The Macroeconomics of Sticky Prices with Generalized Hazard Functions [“Optimal Inattention to the Stock Market With Information Costs and Transactions Costs,”]," The Quarterly Journal of Economics, Oxford University Press, vol. 137(2), pages 989-1038.
    3. Isaac Baley & Andrés Blanco, 2021. "Aggregate Dynamics in Lumpy Economies," Econometrica, Econometric Society, vol. 89(3), pages 1235-1264, May.
    4. David Argente & Chen Yeh, 2022. "Product Life Cycle, Learning, and Nominal Shocks," The Review of Economic Studies, Review of Economic Studies Ltd, vol. 89(6), pages 2992-3054.
    5. Martin Eichenbaum & Nir Jaimovich & Sergio Rebelo, 2011. "Reference Prices, Costs, and Nominal Rigidities," American Economic Review, American Economic Association, vol. 101(1), pages 234-262, February.
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    More about this item

    Keywords

    inflation; relative pric distortions; structural identification;
    All these keywords.

    JEL classification:

    • E31 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Price Level; Inflation; Deflation
    • E58 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Central Banks and Their Policies

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