Academic journal article Quarterly Journal of Business and Economics

The Determinants of Relative Price Variability

Academic journal article Quarterly Journal of Business and Economics

The Determinants of Relative Price Variability

Article excerpt

University of Georgia [*]

This paper investigates how the variability of relative price changes (RPV) is associated with various aspects of inflation. Expected inflation, unexpected inflation, and, to a lesser extent, inflation uncertainty are found to be positively related to RPV. These findings are compared with the predictions of three wellknown models that predict a relationship between some aspect of inflation and RPV: the menu-costs model, the Lucas-Barro signal extraction model, and the Hercowitz-Cukierman extension of the Lucas-Barro model. The findings are consistent with the first model and, to a lesser extent, the second, but are inconsistent with the third.

Introduction

The variability of relative price changes increases with inflation. Studies dating to Mills (1927) and Graham (1930) have consistently found evidence of this variability. [1] The literature, however, is divided on the question of which particular aspect of inflation is most closely related to the variability of relative price changes. The modem literature beginning with Parks (1978) has arrived at various conclusions on this matter, despite consistently defining the variability of relative price changes in period t (more commonly called "relative price variability" and denoted as RPV) as the sum of the squared deviations of rates of change of various price subindexes from the rate of change of an overall price index in period t. [2] Parks finds that RPV increases primarily with the absolute value of unexpected inflation. Tang and Wang (1993) find that RPV increases with expected inflation as well as with the absolute value of unexpected inflation. Fischer (1981a, 1982) finds that RPV increases with expected inflation and positive unexpected inflation, but not with negative unexpected inflation. Still others, such as Grier and Perry (1996) find that RPV increases only with ex ante inflation uncertainty.

Expected inflation, realized (i.e., ex post) unexpected inflation, and ex ante inflation uncertainty all have been proposed as determinants of RPV in well-specified theoretical models, as outlined below. No empirical analysis of the relationship between inflation and RPV has simultaneously included all of these aspects of inflation as explanatory variables. The empirical studies prior to Grier and Perry use only measures of expected and unexpected inflation as explanatory variables. At the same time, while Grier and Perry extend this empirical literature by including a plausible measure of ex ante inflation uncertainty as an explanatory variable, they omit unexpected inflation.

This study investigates the relationship between inflation and RPV using an empirical specification that includes a measure of inflation uncertainty as well as measures of both expected and unexpected inflation. Expected inflation, unexpected inflation, and, to a lesser extent, inflation uncertainty all are found to be positively and significantly related to RPV. These findings shed light on three well-known models that predict a relationship between some aspect of inflation and RPV: the menu-costs model, the Lucas-Barro signal extraction model, and the Hercowitz-Cukierman extension of the Lucas-Barro model. The findings are consistent with the menu-costs model and, to a lesser extent, the Lucas-Barro model, but are inconsistent with the HercowitzCukierman model.

An additional contribution of this paper is the use of a measure of RPV constructed from price data that are more disaggregated than the data used in most previous studies. While most previous studies measure RPV using the subcomponents of the personal consumption expenditure (PCE) deflator or the subcomponents of the producer price index (PPI) at the two-digit level of disaggregation, this study measures RPV using the more numerous subcomponents of PPI at the three-digit level.

The organization of the paper is as follows. First I review the three well-known theories that have been proposed as possible explanations of the relationship between inflation and RPV. …

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