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What Drives the Relationship Between Inflation and Price Dispersion? Market Power vs. Price Rigidity

  • Sascha S. Becker
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    Recent monetary search and Calvo-type models predict that the relationship between inflation and price dispersion is U-shaped, implying an optimal rate of inflation above zero. Moreover, monetary search models emphasize a critical dependence of the real effects of inflation on sellers’ market power, whereas Calvotype models suggest that the degree of price rigidity significantly affects the inflation - price dispersion nexus. Using a new set of highly disaggregated sectoral price data from a panel of European countries, this paper contributes to the literature by testing the empirical relevance of these two theoretical predictions. In line with monetary search theory, a U-shaped profile is found, provided that markups are sufficiently high, but the relationship breaks down under a more competitive environment. Contrarily, no evidence is found to support the contentions of Calvo-type models: U-shaped effects of inflation occur in product sectors with sticky as well as highly flexible prices.

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    File URL: http://sfb649.wiwi.hu-berlin.de/papers/pdf/SFB649DP2011-019.pdf
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    Paper provided by Sonderforschungsbereich 649, Humboldt University, Berlin, Germany in its series SFB 649 Discussion Papers with number SFB649DP2011-019.

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    Length: 38 pages
    Date of creation: Mar 2011
    Handle: RePEc:hum:wpaper:sfb649dp2011-019
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