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Inflation Skewness and Price Indexation

Firouzi Naeim, Peyman and Rahimzadeh, golnoush (2013): Inflation Skewness and Price Indexation.

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One of the two price adjustment (indexation) schemes for the intermediate good producers, in the staggered price Dynamic Stochastic General Equilibrium (DSGE) models is the indexation to the average inflation. In this essay we show that using average of inflation as index multiplier may lead to the deviation from the optimal price for intermediate good producer. Although there is no problem with this indexation method as far as the distribution of inflation is symmetric, when we have a skewed distribution for inflation (as we have in the U.S. economy and most of the G7 countries), indexation to average inflation does not reflect the profit maximizer firm's decision making process. After showing the deficiencies of this method we introduce the Median of the distribution of inflation as an index multiplier, explain its advantage and support our claim by simulating the intermediate firm's profit, in two alternative scenarios of using average inflation and Median of the historic distribution of inflation. Our results suggest that using Median of historic distribution of inflation as index multiplier in staggered price framework, helps intermediate good producer to increase its profit.

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