Inflation versus relative price changes

Inflation Opens in new window refers to a sustained and broad-based increase in the overall price level.

This is distinct from changes in relative prices, which measure the price of one good or service relative to the price of another (or a weighted average of all other goods and services) and signal information about relative surpluses or shortages in different product markets.

A rising relative price of a certain good or service indicates that the demand for it outstrips supply and encourages production while discouraging consumption.

Hence, in contrast to inflation, relative price movements are critical for the efficient allocation of resources.

If goods, services, and factor markets were fully flexible, inflation (which in principle involves no change in relative prices) would not affect the allocation of resources and relative price changes would occur without inflation.

However, if nominal rigidities limit the scope for downward price adjustments, then broad-based inflation can facilitate relative price adjustments by allowing above-average price increases for goods, services, or factors of production that are in high demand (Taylor 2000).

This is particularly relevant to the market for labor because of the general downward rigidity of nominal wages.