[Author Affiliation]Chi-Young Choi, cychoi@uta.eduYoung Se Kim[Acknowledgment]The authors are grateful to coeditor Kent Kimbrough and two anonymous referees for constructive comments that helped to improve this article. The authors also wish to thank Steve Cecchetti, Kang Liu, Shin-Ichi Nishiyama, Margie Tieslau, Taka Tsuruga, and the seminar participants at the Academia Sinica, National Chung Cheng University, National Sun Yat-Sen University, National Taiwan University, Texas Tech University, and the University of Texas at Arlington for helpful comments and Vikas Kakkar for providing CPI data for Hong Kong. Any remaining errors are the authors'.1. IntroductionVariability in relative prices is known to be a major channel through which inflation can induce welfare costs by impeding an efficient allocation of resources in the economy. Consequently, substantial effort has been devoted in the literature to examining the link between relative price variability (RPV) and aggregate inflation. Although much of the existing theoretical and empirical literature points to a positive monotonic relationship, newer contributions suggest that the relationship between inflation and RPV is more complicated, particularly in terms of its sensitivity to the inflation regime.1The primary purpose of this study is to investigate whether the connection between inflation and RPV is influenced in an important way by the monetary policy framework chosen by a central bank. Specifically, this article focuses on exploring whether the adoption of an inflation targeting (IT) framework exerts any significant impact on RPV as measured by the standard deviations of sectoral inflation rates relative to the aggregate rate. Since it was first implemented in New Zealand more than two decades ago, the popularity of IT has spread, with some twenty-five countries worldwide implementing the framework to date (Freedman and Laxton 2009). The literature is now replete with studies pointing to reductions in both the level and the volatility of inflation in countries that have adopted IT (e.g., Mishkin and Schmidt-Hebbel 2007).2 While studies of the impact of IT on aggregate inflation performance are plentiful, little attention has been paid to the impact of IT on RPV.The question of whether and indeed how IT affects RPV is an important one for several reasons. First, exploring the potential connection between IT and RPV is a worthwhile exercise given the popularity of IT as a monetary framework and the centrality of RPV to the current generation of macromodels. The importance of RPV is recognized in standard New Keynesian Dynamic Stochastic General Equilibrium (DSGE) models, where the variance of relative prices is viewed as a useful summary statistic. As noted by Amano, Ambler, and Rebei (2007), for example, in DSGE models, the optimal rate of target inflation and the optimal variability of inflation relative to output depend on the quantitative effects of price dispersion on macroeconomic equilibrium. Second, answering the question helps us identify the driving force behind the change in RPV, distinguishing between IT adoption itself and its subsequent impact on inflation. If the relationship is monotonically positive, as is often believed in the literature, one should expect that IT adoption would bring about a decline in RPV in the same way as it has led to a decline in inflation. If the relationship is more complex, however, the effect of IT adoption on reducing RPV may hinge on the change in inflation regimes after IT adoption. Third, our answer to the question also sheds additional light on the empirical evidence for the relative effectiveness of IT across different stages of development. While there is strong evidence that developing countries benefit more from IT than industrial countries in combating inflation and its volatility (e.g., Petursson 2004; Lin and Ye 2009), we are aware of no empirical research that has assessed this issue with respect to RPV. …
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Nov 11, 2024
Tong Wu 
Open Access