A Panel Smooth Transition Approach to Inflation and Relative Price Variability in China

• Author: Jianfeng Wang,Biao Gu,Yi David Wang
• DOI: http://doi.org/10.1111/rode.12226
• Published date: 01 February 2016
• Date: 01 February 2016

A Panel Smooth Transition Approach to Inflation

and Relative Price Variability in China

Biao Gu, Jianfeng Wang, and Yi David Wang*

Abstract

This paper examines the relationship between inflation and relative price variability (RPV) by using

provincial level data from China. The data contains three different inflation regimes and evidence of

smooth transition is statistically prominent and the province-specific time-varying marginal impact of

inflation on RPV varies substantially across inflation regimes. The inflation–RPV linkage is stronger

when inflation is moderately high, but tends to fade out and might eventually disappear when inflation is

steadily low. The policy implication of this result is that inflation targets should be set within a range in

which the inflation–RPV link is the weakest (i.e. low-inflation regime) to minimize undesirable price

dispersion induced by inflation.

1. Introduction

There has long been a popular consensus among academic researchers and policy

practitioners that the most dominant cost of inflation is not from the average level

of price increase per se, but instead from the inflation-induced dispersion in relative

prices. Unfortunately, studies so far on the empirical relationship between inflation

and relative price variability (RPV) in emerging markets have been scarce. This

paper uses the panel smooth threshold regression (PSTR) model proposed by

Gonzalez et al. (2005) to analyze the empirical inflation–RPV linkage across

provinces in China. It focuses on the high frequency properties and the

determinants of “inter-market” price variability within a province, and both

variations in the time and cross-sectional dimensions can be examined by virtue of

the data set. Therefore, the systematic association between inflation and RPV that

has been obtained mainly along the time series dimension in earlier studies can

now be extended to a panel of cross-sectional units as well.

This paper has two main contributions. First, it enriches the existing literature by

establishing empirically the inflation–RPV nexus in China, a major developing

economy. Second, it provides empirical guidance on the desirable range of inflation

targeting for Chinese monetary authorities in which the distortional impact of

inflation on relative price variability will likely be contained.

*Gu: School of Economics, Shanghai University, No. 99, Shangda Road, Baoshan District, Shanghai,

China 200444. Tel: +86-21-6613-6063; Fax: +86-21-6613-4978; E-mail: billgu@shu.edu.cn. Wang and Wang:

Research Center of Applied Finance, School of Banking and Finance, University of International

Business and Economics, No. 10, Huixin Dongjie, Chaoyang District, Beijing, China 100029. The authors

would like to thank an anonymous referee for his helpful comments and valuable suggestions. All

remaining errors are solely their own. This material is based upon the work financially supported by the

Foundation of the Social Sciences and Humanities Research Council, Ministry of Education of the

People’s Republic of China, under Grant No. 12YJC790042, and by the “Fundamental Research Funds

for the Central Universities” in UIBE (CXTD4-04).

Review of Development Economics, 20(1), 62–73, 2016

DOI:10.1111/rode.12226

©2016 John Wiley & Sons Ltd