The recent literature on the welfare cost of inflation emphasizes inflation's effect on the variability of relative prices. Expected and unexpected inflation have both been proposed to increase relative price variability (RPV) and, thereby, to distort the information content of nominal prices. This paper presents new evidence on the impact of inflation on RPV in Germany. Our results indicate that the influence of expected inflation disappears if a credible monetary policy stabilizes inflationary expectations on a low level. Yet the significant impact of unexpected inflation suggests that even low inflation rates can lead to welfare losses by raising RPV above its efficient level.JEL classification: E31.

In recent macroeconomic theory, relative price variability (RPV) generates the central distortions of inflation. This paper provides first evidence on the empirical relation between inflation and RPV in the euro area focusing on threshold effects of inflation. We find that expected inflation significantly increases RPV if inflation is either very low (below -1.38% p.a.) or very high (above 5.94% p.a.). In the intermediate regime, however, expected inflation has no distorting effects which supports price stability as an outcome of optimal monetary policy. Keywords Non Technical SummaryThere is now a general consensus that inflation produces welfare costs and price stability should be the prior goal of monetary policy. In this regard, recent macroeconomic theory emphasizes the distorting impact of inflation on the information content of nominal prices. If inflation causes a suboptimal adjustment of goods prices due to price adjustment costs or imperfect information, then inflation increases relative price variability (RPV), reduces the transparency of the relative price mechanism and impedes the efficient allocation of resources.The bulk of the empirical literature deals with the linear relationship between inflation and RPV implying that the marginal impact of inflation on RPV does not depend on the inflation level. However, the impact of inflation on the economy might be non-linear.As the empirical literature on the link between inflation and long-term growth shows, the effect of inflation on growth changes if inflation is above certain threshold values of inflation. Moreover, the European Central Bank, for example, defines price stability as an inflation rate below but close to the critical level of 2%.Accounting for a potential non-linear impact of inflation on the economy, this study provides evidence on the empirical relation between inflation and RPV in the euro area focusing on threshold effects of inflation. The application of panel threshold models allows to test for the number of inflation thresholds and to estimate both the threshold levels as well as the marginal impact of inflation on RPV for the various threshold levels of inflation. The empirical results show that threshold effects of inflation can be confirmed for the inflation-RPV nexus in the euro area. In addition to a linear impact of unexpected inflation, there is strong evidence in favor of a non-linear influence of expected inflation on RPV. We find that expected inflation significantly increases RPV if price changes are either clearly negative (< -1.4% p.a.) or very high (> 5.9% p.a.).Between these two thresholds expected inflation has according to our estimations no real effects on the economy via its impact on RPV (but may have other effects).Therefore, threshold effects of inflation provide a further rational for the announcement of critical levels of inflation and inflation target zones. Nicht technische Zusammenfassung

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Inflation, Relative price variability, Cointegration,

Standard-Nutzungsbedingungen:Die Dokumente auf EconStor dürfen zu eigenen wissenschaftlichen Zwecken und zum Privatgebrauch gespeichert und kopiert werden.Sie dürfen die Dokumente nicht für öffentliche oder kommerzielle Zwecke vervielfältigen, öffentlich ausstellen, öffentlich zugänglich machen, vertreiben oder anderweitig nutzen.Sofern die Verfasser die Dokumente unter Open-Content-Lizenzen (insbesondere CC-Lizenzen) zur Verfügung gestellt haben sollten, gelten abweichend von diesen Nutzungsbedingungen die in der dort genannten Lizenz gewährten Nutzungsrechte. optimized prices those models imply a nonlinear and dynamic impact of inflation on the cross-sectional price dispersion (relative-price variability, RPV). Using US sectoral prices we estimate (a generalized form of) the theoretical relationship between inflation and RPV. We confirm the impact of inflation fluctuations but find hitherto neglected endogeneity biases, and our IV and GMM estimates indicate that average ("trend") inflation is significant for indexation. Lagged inflation is less important. Terms of use: Documents in EconStor may

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