Evidence on the Functional Relationship between Relative Price Variability and Inflation with Implications for Monetary Policy

This paper considers the functional relationship between relative price variability (RPV) and inflation using quarterly personal consumer expenditure data in the US over 1967(I)-2003(I), deriving some implications for monetary policy. Non-parametric regression techniques are used to explore the shape of the RPV function, and this shape is related to the theory outlined by J. J. Rotemberg. The empirical RPV function yields a plausible 'optimal' value of inflation in the region of five percentage points, which is consistent with this theory and lies within the range of values cited by recent evaluations of 'sand' and 'grease' effects.