Relative price variability, inflation and the allocative efficiency of the price system

This paper develops a theory of the relationship between aggregate and relative price variability based on the inability of people, even in a rational world, to identify permanent changes in relative demands (whether caused by real or by monetary variability) and relative productivities as soon as they occur. The theory implies that the variance of the rate of inflation and the variance of relative price change are positively related. Although expectations are rational and markets always clear, production decisions respond sluggishly to changes in relative prices. Temporary shocks to relative demands cause prolonged changes in the structure of production. Available information is used so as to maximize the efficiency of the price system. However, this efficiency decreases when any of the underlying variances increases. This decrease is more pronounced when the production lag is longer.