NATIONAL BUREAU OF ECONOMIC RESEARCH
NATIONAL BUREAU OF ECONOMIC RESEARCH

Relative-Price Changes as Aggregate Supply Shocks

Laurence Ball, N. Gregory Mankiw

NBER Working Paper No. 4168 (Also Reprint No. r1961)
Issued in September 1992
NBER Program(s):   EFG   ME

This paper proposes a theory of supply shocks, or shifts in the short-run Phillips curve, based on relative-price changes and frictions in nominal price adjustment. When price adjustment is costly, firms adjust to large shocks but not to small shocks, and so large shocks have disproportionate effects on the price level. Therefore, aggregate inflation depends on the distribution of relative-price changes: inflation rises when the distribution is skewed to the right, and falls when the distribution is skewed to the left. We show that this theoretical result explains a large fraction of movements in postwar U.S. inflation. Moreover, our model suggests measures of supply shocks that perform better than traditional measures, such as the relative prices of food and energy.

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Document Object Identifier (DOI): 10.3386/w4168

Published: Quarterly Journal of Economics, February 1995, p. 161-193

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