Research Discussion Paper – RDP 8007 Inflation and Relative Prices: The Australian Experience


The stylized fact of the inflationary process is that it makes life more uncertain. If prices are increasing rapidly it is argued that there is more noise in the system so that prices convey less information. This implies that people will make wrong decisions if they do not make substantial investments in collecting additional price information. It seems likely that initially people will not catch on to what's happening, not collect the required additional information, and consequently make wrong decisions. For example, in times of inflation a shopper at a supermarket would have to make literally thousands of pairwise price comparisons in order to have full information about the new price structure. Such a large information requirement clearly does not make life any easier for shoppers and it is likely that they would respond by learning about the new price structure not immediately, but over time.

These general notions about the uncertainty effects of inflation have a great deal of intuitive appeal. But very little formal research has been devoted to understanding these issues. In this paper we analyse one aspect of the area, the distortive effects of inflation on relative prices. Using quarterly Australian data for consumer prices, we find that inflation does systematically change relative prices; i.e. some prices consistently rise by more than the overall rate of inflation and some consistently rise by less.

This means that inflation (i) causes costly resource reallocations and changes in consumption patterns; and (ii) makes it more difficult to forecast prices, which raises the degree of uncertainty in the economy.

To illustrate the results, in Table 1 we give the percentage of the variability of each consumer price due to (i) inflation and (ii) real changes in the economy (changes in income, tastes, technology, etc.). As can be seen, 19 per cent of the variability of the price of food is due to inflation and the remaining 81 per cent is due to real factors. The last row of the table gives the inflation and real percentages for all relative price changes. These totals are weighted averages of the corresponding individual commodity percentages. Inflation accounts for 24 per cent of the total relative price variability.

Our results indicate that the distortion of relative prices is substantial and should be included in any evaluation of the cost of inflation.