Discussion Paper Series 2019-E-11

Self-Organization of Inflation Volatility

Makoto Nirei, Jose A. Scheinkman

We present a state-dependent pricing model that generates inflation fluctuations from idiosyncratic shocks to the cost of price changes of individual firms. A firm's nominal price increase, lowers other firms' relative prices, thereby inducing further nominal price increases. This snow-ball effect of repricing causes fluctuations to the aggregate price level without exogenous aggregate shocks. The fluctuations caused by this mechanism are more volatile when the density of firms at the repricing threshold is high, and the density at the threshold is high when the trend inflation level is high. Thus, the model implies that higher trend inflation produces larger volatility of short-term inflation rates. Analytical and numerical analyses show that the model can account for the positive relationship between inflation level and volatility that has been observed empirically.

Keywords: Trend inflation; Inflation volatility; State-dependent pricing; Aggregate fluctuations; Self-organized criticality; Power law

Views expressed in the paper are those of the authors and do not necessarily reflect those of the Bank of Japan or Institute for Monetary and Economic Studies.

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