Relative Price Distortions and Inflation Persistence

Abstract

Sticky-price models often suggest that relative price distortion is a major cost of inflation. We provide an intuition for this: Even at low rates, inflation strongly affects price dispersion which in turn has an impact on the economy qualitatively similar to, and of the order of magnitude of, a negative shift in productivity. The utility cost of price dispersion is quantified and its impact on optimal monetary policy discussed. Price dispersion is incorporated into a linearised model. Strikingly, a contractionary nominal shock has a persistent, negative hump-shaped impact on inflation but may have a positive hump-shaped impact on output.This article investigates the macroeconomic implications of relative price distortions as this is where many, though not all, sticky-price models locate the costs of inflation. 1 First, we quantify how costly price dispersion is in a standard macroeconomic model with imperfect competition and price rigidity as in Calvo (1983). Despite being very costly in welfare terms, price dispersion is generally considered to be a term of secondorder importance in linearised models. That is why many economists conclude that the direct impact of price dispersion on welfare is small (Canzoneri et al., 2004). However, in economies with, say, trend inflation of 2-3%, no indexation and a degree of nominal price inertia, price dispersion, viewed through the lens of our simple model, will be an important (first-order) variable. The key margins that are distorted by price dispersion are identified and we develop what we think is a useful intuition on the costs of dispersion which has not been identified hitherto: price dispersion impacts on the economy like a negative productivity shock and so inflation surprises are far from costless in this set-up.

Trend Inflation and Firms Price‐Setting: RotembergVersusCalvo

“…where, as explained in Damjanovic and Nolan (2010),ŵ t is the expected discounted marginal revenue for the firms updating their price in the current period. k, g, j and n are complicated convolution parameters that depend on trend inflation, k ½1 À h p ðeÀ1Þ ð1 À hb p e Þ h p ðeÀ1Þ ; g bð p À 1Þ½1 À h p ðeÀ1Þ ; j k ð p;eÞ ðr þ uÞ þ g ð p;eÞ ð1 À rÞ; n eh p ðeÀ1Þ ð p À 1Þ 1 À h p ðeÀ1Þ :…”

“…Moreover, they show that the variability of most aggregate variables increases with trend inflation. Damjanovic and Nolan (2010) show that a contractionary monetary shock has a persistent, negative hump‐shaped impact on inflation and a positive hump‐shaped impact on output. They quantify the utility cost of price dispersion and its impact on optimal monetary policy.…”

“…11 11 In a recent paper, Damjanovic and Nolan (2010) show that, in a model with low trend inflation, a negative monetary shock can have a persistent and hump‐shaped impact on output and a positive impact on inflation. …”

“…In a recent paper,Damjanovic and Nolan (2010) show that, in a model with low trend inflation, a negative monetary shock can have a persistent and hump-shaped impact on output and a positive impact on inflation.12 In the Rotemberg model vector x t in the representation(38)includes two non-predetermined variables, i.e. x t ½ŷ t ;p t ; 0 .…”

On the Welfare Gains of Price Dispersion

“…At high levels of inflation, however, the extensive margin effect is more than offset by the intensive margin effect. As a result, under high rates of inflation, price dispersion lowers welfare, as in Head and Kumar (2005) and in the New Keynesian framework as illustrated in Damjanovic and Nolan (2010) 1…”