Relative-Price Change as Aggregate Supply Shocks
This paper proposes a theory of supply shocks, or shifts in the short-run Phillips curve, based on relative-price changes and frictions in nominal price adjustment. When price adjustment is costly, firms adjust to large shocks but not to small shocks, and so large shocks have disproportionate effects on the price level. Therefore, aggregate inflation depends on the distribution of relative-price changes: inflation rises when the distribution is skewed to the right, and falls when the distribution is skewed to the left. The authors show that this theoretical result explains a large fraction of movements in postwar U.S. inflation. Moreover, their model suggests measures of supply shocks that perform better than traditional measures, such as the relative prices of food and energy. Copyright 1995, the President and Fellows of Harvard College and the Massachusetts Institute of Technology.
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