Relative prices, the price level and inflation: Effects of asymmetric and sticky adjustment

Abstract

The paper examines how relative price shocks can affect the price level and then inflation. Using Indian data we find: (i) price increases exceed price decreases. Aggregate inflation depends on the distribution of relative price changes—inflation rises when the distribution is skewed to the right, (ii) such distribution based measures of supply shocks perform better than traditional measures, such as prices of energy and food. They moderate the price puzzle, whereby a rise in policy rates increases inflation, and are significant in estimations of New Keynesian aggregate supply, (iii) an average Indian firm changes prices about once in a year; the estimated Calvo parameter implies half of Indian firms reset their prices in any period, and 66 percent of firms are forward looking in their price setting. The implication of these estimated real and nominal price rigidities for policy are drawn out.