Tuesday, December 6, 2016

Relative Price Variability and Inflation: New Evidence



RelativePrice Variability and Inflation: New Evidence


One sentence summary: There is a hump-shaped relationship between relative price variability (RPV) and inflation, where the negative real effects of RPV on the economy are maximized when annual inflation is about 20 percent.

The corresponding paper by Deniz Baglan, Ege Yazgan and Hakan Yilmazkuday has been published in Journal of Macroeconomics.

The working paper version is available here.

Abstract
This paper investigates the relationship between relative price variability (RPV) and inflation using monthly micro price data for 128 goods in 13 Turkish regions/cities for the period 1994--2010. The unique feature of this data set is the inclusion of annual inflation rates ranging between 0 percent and 90 percent. Semi-parametric estimations show that there is a hump-shaped relationship between RPV and inflation, where the maximum RPV is achieved when annual inflation is approximately 20 percent. It is shown that this result is consistent with a region- or city-level homogenous menu cost model featuring Calvo pricing with an endogenous contract structure and non-zero steady-state inflation.


Non-technical Summary
Inflation may have real effects on an economy. Among others, one channel is through relative price variability (RPV) that corresponds to different sectors experiencing alternative increases in their prices. An increase in RPV not only associated with higher uncertainty through noisy price information and thus inefficient supply but also a redistribution of wealth across sectors due to the real effects on production (alternative price changes in revenues versus costs) and on individual consumption (alternative price changes in sector-specific wages versus a common inflation). Therefore, the higher the RPV, the higher the negative real effects are on the economy.

In a recent paper, together with Deniz Baglan and Ege Yazgan, we investigate how RPV changes with the level of inflation ranging between 0 percent and 90 percent by using data on Turkish product-level prices. The following figure shows the median, minimum, and maximum levels of inflation across products:


Using semi-parametric regressions, we show that there is a hump-shaped relationship between RPV and inflation, where the maximum RPV is achieved when annual inflation is approximately 20 percent.


Therefore, the negative effects of inflation through RPV are experienced the most when inflation is about 20 percent. Since the periods between 1995-2001 and 2004-2010 correspond to low-inflation and high-inflation periods, respectively, it is also implied that the negative real effects of inflation through RPV have been minimized when inflation was about 6 percent during the 2004-2010 period and about 30 percent during the 1995-2001 period.

We also show that this hump-shaped relation between RPV and inflation is consistent with a homogenous menu cost model featuring Calvo pricing, an endogenous contract structure, and non-zero steady-state inflation.










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