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• W3123413896 abstract "LARGE literature in macroeconomics has examined how the inflation rate is related to the distribution of relative-price changes. This work has established a striking fact: there is a strong correlation between inflation and the skewness of this distribution. When inflation is high, the distribution of relative-price changes is typically skewed to the right; when inflation is low, it is skewed to the left. The oil shocks of the 1970s are one example of this phenomenon: inflation rose while a few goods (oil products) experienced especially large relative-price increases. But the inflationskewness correlation is not just a result of oil-shock years. This fact holds for many time periods and many countries (e.g., Vining & Elwertowski (1976) and Ball & Mankiw (1995) for the United States; Amano & Macklem (1997) for Canada; De Abreu Lourenco and Gruen (1995) for Australia). Bryan and Cecchetti (1999) argue that this fact ‘‘need not be a fact at all,’’ because of ‘‘small-sample bias.’’ If true, this is an important claim. It would eliminate an apparently robust stylized fact that might otherwise hold a clue to understanding the causes or effects of inflation. We are not, however, convinced by Bryan and Cecchetti’s assertion. Our goal in this note is to explain why. On its face, Bryan and Cecchetti’s claim is puzzling. Their paper presents a model in which there is an underlying true distribution of price changes, and the observed distribution is obtained by sampling a subset of these price changes. They show that the skewness of the sample distribution may be correlated with the sample mean even if there is no skewness in the population distribution. This model, however, does not capture the reality of how price indices are constructed. It is not the case that there are a large number of sectors, and the government computes the CPI by sampling a small number of them. Instead, the government measures prices in all sectors (of which there may be a small or large number depending on the level of disaggregation). The observed correlation of the mean and skewness is based on the full population of sectors. So ‘‘small-sample bias’’ does not appear to be possible. Because the data used to construct price indices are comprehensive, one cannot avoid the conclusion that the inflation-skewness correlation is a fact. 1 If the idea of small sample bias is not relevant here, how should one interpret the numerical simulations presented by Bryan and Cecchetti? The substance of their argument, we believe, is that it is easy to explain the correlation between inflation and skewness. Previous authors have worked hard to explain this fact: Ball and Mankiw (1995) propose that this correlation can be explained with ‘‘menu cost’’ models of price adjustment, while Balke and Wynne (1996) argue that it can be explained by a multisector, real-business-cycle model. By contrast, Bryan and Cecchetti generate the inflation-skewness correlation in a much simpler model. Although it would be wrong to interpret their results as showing that the correlation doesn’t exist, one could plausibly interpret them as showing that this correlation doesn’t prove anything. As they put it, ‘‘such statistics are not useful in distinguishing sticky from flexible price-setting behavior in macroeconomic models.’’ To evaluate this argument, it helps to step back and review the motivation behind the Ball-Mankiw and Balke-Wynne theories. The starting point for these authors is the classical theory of price determination. Central to this theory is the classical dichotomy: relative prices are determined by real factors, and the aggregate price level is determined by monetary factors. Specifically, if there are N sectors in the economy, there are N-1 relative prices. Real variables, such as shifts in demand and costs in the various sectors, determine these N-1 prices, using any good or combination of goods as the numeraire. The aggregate price level is determined by the supply and demand for money; this idea is summarized by the quantity equation, MV 5 PY. The N-1 relative prices and the price level, which equals the average of all nominal prices, together determine the N nominal prices. In this classical model, there is no obvious reason that the behavior of the aggregate price level is related to the distribution of relative prices. If M, V, and Y remain constant, then P is constant, and any shifts in the distribution of relative prices do not influence the price level. To explain the observed inflation-skewness correlation, one must explain how the economy differs from this classical baseline. Balke and Wynne offer one story for the inflationskewness correlation. In their model, certain shocks to the economy generate both skewness in the relative-price distribution and changes in aggregate output. For instance, when OPEC raised oil prices, relative prices in energy-related sectors rose by 50% or more, balanced by smaller relativeprice decreases in the rest of the economy. This generated" @default.
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• W3123413896 modified "2023-09-27" @default.
• W3123413896 title "Interpreting the Correlation Between Inflation and the Skewness of Relative Prices: A Comment on Bryan and Cecchetti" @default.
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