INFLATION, INFLATION UNCERTAINTY, AND RELATIVE PRICE DISPERSION - EVIDENCE FROM BIVARIATE GARCH-M MODELS

One potential real effect of inflation is its influence on the dispers ion of relative prices in the economy. Menu cost models generally impl y that higher trend inflation will increase price dispersion. In contr ast, signal extraction models predict that increased inflation uncerta inty will raise relative price dispersion. Existing empirical studies do not distinguish between these separate hypotheses. We constuct a bi variate GARCH-M model of inflation and relative price dispersion to te st these differing explanations in a single model and find that inflat ion uncertainty dominates trend inflation as a predictor of relative p rice dispersion.