Price Stickiness and Inflation

A recent model of firms’ pricing behaviour by Laurence Ball and Gregory Mankiw has novel implications for the effect of relative price shocks on inflation. This paper examines these implications and establishes the importance of expected inflation for this story. We derive the model relationship between expected inflation, the economy-wide distribution of industry price changes and actual inflation, and show that both Australian and US industry-price data strongly support this derived relationship. The inflationary impact of relative price shocks depends strongly on expected inflation. When expected inflation is high, a rise in the economy-wide dispersion of shocks is inflationary in the short-run. By contrast, when expected inflation is low, a rise in the dispersion of shocks has minimal impact on inflation. Economy-wide relative price shocks, like terms of trade shocks, are an unavoidable feature of the economic landscape. Their disruptive effect on inflation is minimal, however, when average inflation, and therefore average expected inflation, is kept low.