Inflation and relative price variability in the euro area: evidence from a panel threshold model

Abstract

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

Is 2 % the optimal inflation rate for the Euro Area?

“…3 Moreover, recent research presents three types of evidence. Firstly, Nautz and Scharff (2005) for Germany, and Nautz and Scharff (2012) for the EA find that RPV is increasing in inflation even in low inflation environments. Secondly, Bick and Nautz (2008), in a panel threshold model for several USA cities verify positive and negative effects of inflation on RPV, while the suggested annual inflation to minimize RPV is in the range of 1,8-2,8%.…”

Evidence on the functional form of inflation and output growth variability relationship in European economies

“…Second, some other studies on the inflation-RPV relationship contradict the linear functional form of this relationship, assumed by the monetarists. The examples include Fielding and Mizen (2008) and Nautz and Scharff (2012), showing a nonlinear functional form of this nexus. This nonlinear profile of the inflation-RPV relationship calls for a positive inflation rate to minimize the RPV.…”

Relative price variability and inflation: New evidence

“…Results for the Euro area presented by Nautz and Scharff (2012), indicate that inflation significantly increases RPV only if inflation is either very low or very high in the range of their sample values. 3 More recently, conformable with recent monetary search and Calvo-type model predictions (see Head andKumar, 2005 andChoi, 2010), evidence has been provided of a U-shaped relationship between inflation and RPV by Choi (2010) for the US and Japan, Choi and Kim (2010) for the US, Canada and Japan, Becker (2011) for a panel of European countries, and Fielding and Mizen (2008) for the US.…”