Working Paper: CEPR ID: DP13027
Authors: Ivan Petrella; Emiliano Santoro; Lasse De La Porte Simonsen
Abstract: We study how and to what extent inflation dynamics is shaped by time variation in the capacity of nominal demand to stimulate price adjustment. Using microdata underlying the UK consumer price index, we estimate a generalized Ss model of lumpy price adjustment, and condense large cross-sectional information on micro price changes into a measure of price flexibility. The latter displays sizable time variation, which maps into a marked non-linearity of inflation dynamics: the half-life of the rate of inflation is twice as large in periods of relatively low flexibility, along with appearing remarkably close to the one observed in a linear setting. Changes in firms' price-adjustment cost structure, as reflected in the adjustment hazard, are key to account for state dependence in price setting. Neglecting these facts may severely bias our understanding of inflation dynamics.
Keywords: inflation; price flexibility; SS models
JEL Codes: E30; E31; E37; C22
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| time variation in price flexibility (P22) | inflation dynamics (E31) |
| price flexibility (D41) | variability in inflation forecast errors (E31) |
| changes in firms' price-adjustment cost structure (L11) | state dependence in price setting (L11) |
| adjustment hazard (C41) | understanding of state dependence in price setting (L11) |
| nominal shocks (E39) | response of aggregate inflation (E31) |
| price flexibility (D41) | half-life of inflation (E31) |