Relative Goods ’ Prices , Pure Inflation , and The Phillips Correlation

O ne of the goals of macroeconomics is to explain the aggregate sources of changes in goods' prices. If there was a single consumption good in the world, as is often assumed in models, describing the price changes of consumption would be a trivial matter. But, in reality, there are many goods and prices, and there is an important distinction between price changes that are equiproportional across all goods (absolute-price changes) and changes in the cost of some goods relative to others (relative-price changes). The goal of this paper is to empirically separate these sources of price changes and to investigate their relative size, their determinants, and their role in the macroeconomic Phillips relation between inflation and output. Our data are the quarterly price changes in each of 187 sectors in the US personal consumption expenditures (PCE) category of the national income and product accounts from 1959:Q1 to 2006:Q2. Denoting the rate of price change for the i'th good between dates t − 1 and t by π it , and letting π t be the N × 1 vector that collects these goods' price changes, we model their co-movement using a linear factor model: (1) π t = ΛF t + u t .). We are grateful to several colleagues for their valuable input to this research project. For their support and hospitality, Reis thanks the This paper uses a dynamic factor model for the quarterly changes in consumption goods' prices in the United States since 1959 to separate them into three independent components: idiosyncratic relative-price changes, a low-dimensional index of aggregate relative-price changes, and an index of equiproportional changes in all inflation rates that we label " pure " inflation. We use the estimates to answer two questions. First, what share of the variability of inflation is associated with each component, and how are they related to conventional measures of monetary policy and relative-price shocks? Second, what drives the Phillips correlation between inflation and measures of real activity? (JEL E21, E23, E31, E52)