Summary of WP/92/88
“Are Prices Countercyclical?” by Bankim Chadha and Eswar Prasad
This paper examines the co-movement of prices with the cyclical component of output. It argues that applying the same stationarity-inducing transformation to the levels of output and prices and then examining the correlations of the resulting series is not a reliable way to determine the cyclical behavior of prices. A more appropriate procedure is to examine the correlations between the rate of inflation and the level of the cyclical component of output. If cyclical movements in output result primarily from movements in demand, the cross - correlations should be positive; if they result primarily from movements in supply, the cross-correlations should be negative.
In postwar U.S. data, the correlations between similarly transformed price and output data are consistently and often strongly negative, as reported recently by a number of authors (Kydland and Prescott (1990), Backus and Kehoe (1991), and Cooley and Ohanian (1991)) as evidence of countercyclical price behavior. However, the rate of inflation has a consistent and, usually, a strong positive correlation with various measures of the cyclical component of output estimated under alternative assumptions on the long-run behavior of output. These latter results are consistent with prices having been procyclical in the postwar United States and with the view that temporary movements in output are primarily associated with movements in demand.
Two simple macroeconomic models, a demand-driven sticky price model and a supply-driven flexible price model, are used to illustrate the arguments and to help reconcile some of the conflicting findings. Simulations of the models suggest that examining the cross-correlations between similarly transformed price and output data can easily yield negative correlations even when prices are, by construction, procyclical. For both models, correlations between the rate of inflation and the cyclical component of output are shown to reflect the cyclical behavior of prices accurately.