DP18088 Inflation Distorts Relative Prices: Theory and Evidence
Using a novel identification approach derived from sticky price theories with time or state-dependent adjustment frictions, we empirically identify the effect of inflation on relative price distortions. Our approach can be directly applied to micro price data, does not rely on estimating the gap between actual and flexible prices, and only assumes stationarity of unobserved shocks. Using U.K. CPI micro price data, we document that suboptimally high (or low) inflation is associated with distortions in relative prices that are highly statistically significant. At the aggregate level, fluctuations in inefficient price dispersion are sizable and covary positively with aggregate inflation. In contrast, overall price dispersion fails to covary with inflation because it is mainly driven by trends in the dispersion of flexible prices.