Relative Shocks, Relative Price Variability, and Inflation

THE COEXISTENCE of high inflation and low real growth has received its share of attention in the attempts to understand the U.S. economic performance of the 1970s. Analytic contributions in the imperfect information market-clearing framework have shown how uncertainty about inflation can reduce the efficiency of the price system and how relative price variability is likely to be greater when there are unanticipated changes in the price level. Such analyses, combined with the assumption that high inflation rates are also more uncertain, provide a rationalization for the view that inflation may itself be a factor explaining the poor performance of the United States and other industrial economies after 1973. The relation between the rate of inflation and its variability was debated in Brookings Papers in 1971. In this paper I investigate a related issue: the relation between inflation and relative price variability. I discuss various explanations of a causal relation between inflation and relative price variability and provide estimates of the share of relative price variability that can be attributed to monetary and fiscal policy.1 In ex-