DP13027 Time-varying Price Flexibility and Inflation Dynamics

Author(s): Lasse de la Porte Simonsen, Ivan Petrella, Emiliano Santoro
Publication Date: July 2018
Date Revised: September 2019
Keyword(s): inflation, price flexibility, Ss models
JEL(s): C22, E30, E31, E37
Programme Areas: Monetary Economics and Fluctuations
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=13027

We study how and to what extent inflation dynamics is shaped by time variation in the capacity of nominal demand to stimulate price adjustment. Using microdata underlying the UK consumer price index, we estimate a generalized Ss model of lumpy price adjustment, and condense large cross-sectional information on micro price changes into a measure of price flexibility. The latter displays sizable time variation, which maps into a marked non-linearity of inflation dynamics: the half-life of the rate of inflation is twice as large in periods of relatively low flexibility, along with appearing remarkably close to the one observed in a linear setting. Changes in firms' price-adjustment cost structure, as reflected in the adjustment hazard, are key to account for state dependence in price setting. Neglecting these facts may severely bias our understanding of inflation dynamics.