SFB 649 Discussion Paper 2011-019 What Drives the Relationship Between Inflation and Price Dispersion? Market Power vs. Price Rigidity

Recent monetary search and Calvo-type models predict that the relationship be-tween inflation and price dispersion is U-shaped, implying an optimal rate of inflation above zero. Moreover, monetary search models emphasize a critical de-pendence of the real effects of inflation on sellers ’ market power, whereas Calvo-type models suggest that the degree of price rigidity significantly affects the in-flation- price dispersion nexus. Using a new set of highly disaggregated sectoral price data from a panel of European countries, this paper contributes to the litera-ture by testing the empirical relevance of these two theoretical predictions. In line with monetary search theory, a U-shaped profile is found, provided that mark-ups are sufficiently high, but the relationship breaks down under a more compet-itive environment. Contrarily, no evidence is found to support the contentions of Calvo-type models: U-shaped effects of inflation occur in product sectors wit