What drives the relationship between inflation and price dispersion? Market power vs. price rigidity

Sascha Becker

No 2011-019, SFB 649 Discussion Papers from Humboldt University Berlin, Collaborative Research Center 649: Economic Risk

Abstract: Recent monetary search and Calvo-type models predict that the relationship between inflation and price dispersion is U-shaped, implying an optimal rate of inflation above zero. Moreover, monetary search models emphasize a critical dependence of the real effects of inflation on sellers' market power, whereas Calvotype models suggest that the degree of price rigidity significantly affects the inflation - price dispersion nexus. Using a new set of highly disaggregated sectoral price data from a panel of European countries, this paper contributes to the literature by testing the empirical relevance of these two theoretical predictions. In line with monetary search theory, a U-shaped profile is found, provided that markups are sufficiently high, but the relationship breaks down under a more competitive environment. Contrarily, no evidence is found to support the contentions of Calvo-type models: U-shaped effects of inflation occur in product sectors with sticky as well as highly flexible prices.

Keywords: inflation; relative price variability; price level index; Euro-area; market structure; monetary search model; dynamic panel data models (search for similar items in EconPapers)
JEL-codes: C23 D40 E31 F15 (search for similar items in EconPapers)
Date: 2011
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