Relative Price Variability and Inflation in the UK

Reducing inflation became the major economic policy target for many governments in the late 1970s. A long list of costs were thought to be associated with higher inflation, including the unplanned redistribution of income and wealth, distorted real taxation rates, and the misallocation of resources which arose as agents became more confused about the true value of the aggregate price level, and hence relative prices themselves. This chapter is concerned with the latter phenomenon: the extent to which both the uncertainty attached to forecasts of the aggregate price level, and the variation in the relative prices of goods and services, rise as inflation rises. It is often stated in policy debates that higher inflation is associated with more variable inflation and (hence) greater uncertainty about future prices: this is believed to deter entrepreneurs from investing. However, not only are future price levels more difficult to estimate, but the current aggregate price level is also unknown. In a world where collecting information is costly individual agents typically possess different information. This leads to confusion about current relative prices since agents only know ‘local’ prices precisely and guess the rest. The mistakes associated with rapidly changing relative prices were certainly perceived as being an important cost of inflation by the UK authorities. These keywords were added by machine and not by the authors. This process is experimental and the keywords may be updated as the learning algorithm improves.