On Business-cycle Asymmetries of the Relationship between Inflation and Relative Price Variability

This paper examines if the joint behavior of inflation and relative price variability (RPV) is consistent with threshold nonlinearity. It applies the test procedure proposed by Tsay (1998) to monthly inflation and RPV in the U.S. for a period from January 1947 to October 2000, and finds strong evidence in favor of threshold nonlinearity that signifies asymmetries of the relationship between inflation and RPV across expansionary and contractionary business cycle regimes. It then estimates a structural, tworegime, bivariate threshold model in which the fundamental innovations are identified by imposing covariance and Blanchard and Quah restrictions. The forecast –error variance decomposition results indicate that the temporary innovations are relatively more important for inflation fluctuations in the contractionary regime than in the expansionary regime. However, the permanent innovations, in general, dominate in both regimes. On the other hand, temporary innovations are more important for RPV variance both in expansionary and contractionary regimes. But in the contractionary regime the permanent innovations not only have relatively larger effects on RPV fluctuations as compared to those in the expansionary regime, but also their contribution increases substantially over forecast horizons. JEL Classification: E3