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In Search of Optimal Inflation
The impact of inflation on dispersion of relative prices is examined in a cointegration framework using a data set of all seven components of the consumer price index from India. The empirical evidence indicates that the dispersion of relative price increases with an increase in deviation of inflation from a certain threshold rate in either direction but not with inflation per se, as is traditionally believed. The crucial inference that emerges from the empirical findings is the presence of a threshold inflation rate corresponding to which the dispersion of relative prices is minimised, and this threshold turns out to be 5%.
The author would like to thank the anonymous referees for their valuable comments and suggestions on the earlier draft of this article.
In an economy, the structure of relative prices varies due to changes in both real factors (which include tastes/preferences, real income, technology, etc) and the nominal factors such as inflation (Parks 1978). The variability in relative prices due to changes in real factors is considered useful for the efficient allocation of resources, as these changes reflect signals purely from the market forces and real sector of an economy. However, the changes in relative price structure mainly due to inflation are believed to generate adverse distortions by: (i) reducing the information content of relative prices; (ii) increasing search activities which are costly; (iii) shortening the length of optimal contracts and triggering more frequent contract revisions, and thereby impeding the efficient allocation of resources.1 In fact, as emphasised by the new Keynesian dynamic general equilibrium models, the distortionary impact of inflation on the structure of relative prices is one central channel through which the negative effects of inflation transmit to the real sector of an economy (Green 2005; Becker and Nautz 2012). In this context, in order to ensure that the fluctuations in inflation rate do not trigger any significant changes in relative prices, the monetary authority’s commitment to the objective of price stability is very critical. Also, equally important is choosing an appropriate optimal/desired inflation target for the effective operation of monetary policy.
Theoretically, the link between variability of relative prices and inflation originates from the models based on misperceptions and incomplete information (Lucas 1973; Head and Kumar 2005), and the models assuming menu costs in price adjustment of firms (Sheshinsky and Weiss 1977; Rotemberg 1983; Ball and Mankiw 1994, 1995). More specifically, in models based on incomplete information, the firms with relatively price elastic supply adjust the quantity of output quite often in response to the shocks in demand. However, the firms whose supply is relatively inelastic will adjust prices (rather than quantity of output) in response to the demand shocks. Hence, the demand shocks that result in higher inflation tend to generate more variability in relative prices. The menu cost models demonstrate that firms adjust prices only at discrete intervals and the adjustment is heterogeneous as it incurs costs, which differ across firms. Under these conditions, the price changes get more dispersed during the periods of higher inflation, which in turn result in larger variability in relative prices. Building on Friedman (1977), Ball (1992) provided an alternative explanation that during the periods of high inflation, the public expects/perceives erratic policy response by the monetary authorities as policy changes from one direction to another. In such a situation, predicting the short-term fluctuations as well as the long-term trend in inflation become more difficult (Friedman 1977), and more importantly, the individual prices drift apart significantly in a dynamic manner, thereby causing higher dispersion of relative price over time (Shoesmith 2000).
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