Inflation and relative-price changes in the Swedish economy

Shocks to diverse markets generate changes in relative prices ‐ some nominal prices rise, others fall. If all prices were perfectly flexible, such price movements would largely cancel out and leave inflation unaffected. In practice, however, certain prices tend to be sticky because price adjustments are costly. In such cases, prices are adjusted quickly only in the event of large shocks, not when the shocks are small. The positively skewed distribution of relative-price changes then results in a temporary increase in inflation. This has been the case in Sweden and explains a large part of the short-run fluctuations in CPI inflation over the past quarter-century. The variance and skewness of relative-price changes also explain shortcomings in existing models of inflation. Rigidities in connection with major and minor shocks A familiar phenomenon in the analysis of price-setting and inflation is the sizeable rigidities that occur in price adjustments and the marked differences in this respect between firms. Due to these rigidities, various market conditions may change without leading to the price adjustment that should normally occur. A basic explanation for these rigidities is that the costs associated with altering prices may make it more profitable to abstain from or postpone an adjustment. The cost of price adjustment makes a price change more probable if the market shock is large than if it is small. If a few large shocks that motivate relative-price increases are countered by numerous small shocks that call for relative-price reductions, it may be mainly the increases that actually occur as nominal-price adjustments. Such a positively skewed distribution of relative-price changes implies increased inflation, while a distribution that is negatively skewed lowers inflation. When this theory was put forward and tested in the mid