Working Paper: CEPR ID: DP14335
Authors: Klaus Adam; Henning Weber
Abstract: Using the official micro price data underlying the U.K. consumer price index, we document a new stylized fact for the life-cycle behavior of consumer prices: relative to a narrowly defined set of competing products, the price of individual products tends to fall over the product lifetime. We show that this data feature has important implications for the optimal inflation target. Constructing a sticky-price model featuring a product life cycle and heterogeneous relative-price trends, we derive closed-form expressions for the optimal inflation target under Calvo and menu-cost frictions. We show how the optimal target can be estimated from the observed trends in relative prices. For the U.K. economy, we find the optimal target to be equal to 2.6% in 2016. It has steadily increased over the period 1996 to 2016 due to changes in relative price trends over this period.
Keywords: optimal inflation; micro price data; UK inflation target
JEL Codes: E31
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| product lifecycle characteristics (L15) | optimal inflation targeting (E31) |
| relative price behavior (P22) | optimal inflation targeting (E31) |
| relative price declines (E30) | welfare implications (I30) |
| optimal inflation target (E31) | relative price distortions (P22) |
| product lifecycle behavior (L15) | relative price declines (E30) |
| price rigidity and product heterogeneity (L11) | optimal inflation target (E31) |