Inflation, Fixed Cost of Price Adjustment, and Measurement of Relative-Price Variability: Theory and Evidence

Rotemberg's (1983) theoretical framework is used to demonstrate that the proxy for relative-price variability adopted in the empirical literature does not properly capture the relative-price variability that is caused by a fixed cost of price adjustment. The methodology of previous studies is not appropriate for evaluating the empirical relevance of the fixed-cost theory, and the divergence of previous results is not surprising. Specifically, the proxy that consists of the variance of the rates of price change between successive observations does not always increase with the anticipated inflation. Furthermore, the relationship between the anticipated inflation and the proxy depends on such extraneous factors as the timing of the observations. A change in the timing can change a positive relationship between the anticipated inflation and the proxy to a negative one, and vice versa. Alternative, more satisfactory measures of relative-price variability are proposed, and empirical support is provided for the theoretical conclusions.