DP13027 | Inflation Dynamics and Price Flexibility in the UK

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Using microdata underlying the UK consumer price index we study how the capacity of nominal demand shocks to stimulate the rate of inflation has evolved over the last two decades. To this end, we estimate a generalized Ss model of lumpy price adjustment, and document sizeable time variation in the behavior of price flexibility. Most notably, the latter shoots up in the aftermath of the Great Recession and rapidly falls thereafter, with these sharp movements reflecting into increased inflation volatility. These features map into a marked non-linearity of inflation dynamics with respect to the degree of price flexibility, with mean reversion being significantly faster when prices are relatively more flexible. State dependence plays a major role for price setting at the microeconomic level, and more so when inflation is particularly high and volatile. Neglecting these facts may severely bias our understanding of inflation dynamics.