Inflation and relative-price variability in the open economy

This paper explores the determination of relative-price variability in a small open economy operating under a fixed exchange rate. A central ingredient of the model presented is the distinction made between traded and non-traded goods. This distinction leads to a decomposition of total variability into three components: the variabilities within each set of goods and between the two sets. The analysis also emphasizes the effects of expected versus unexpected inflation on the variability of relative prices. The model is tested using annual data for Mexico, covering the 1951-76 period.