Evidence on the effects of inflation on price dispersion under indexation

Abstract

Distortionary effects of inflation on relative prices are the main argument for inflation stabilization in macro models with sticky prices. Under indexation of non-optimized prices, those models imply a nonlinear and dynamic impact of inflation on the cross-sectional price dispersion (relative price or inflation variability, RPV). Using US sectoral price data, we estimate such a relationship between inflation and RPV, also taking into account the endogeneity of inflation by using two- and three-stage least-squares and GMM techniques, which turns out to be relevant. We find an effect of (expected) inflation on RPV, and our results indicate that average (“trend”) inflation is important for the RPV–inflation relationship. Lagged inflation matters for indexation in the CPI data, but is not important empirically in the PPI data.