A stylized fact that has served as a fundamental datum in the construction of a large class of business cycle models is the procyclical behavior of prices. A number of recent papers have shown that the cyclical components of prices and output are in fact negatively correlated and have interpreted this finding as a falsification of the conventional wisdom that prices are procyclical.
However, the traditional focus of many business cycle models has been the inflation rate rather than the price level. The objective of this paper is to provide a set of stylized facts for the main industrial economies that clearly differentiates between the cyclical behavior of inflation and the price level. This distinction is potentially important in discriminating between theoretical models on the basis of stylized facts. This distinctior is also important for empirical models of the business cycle in motivating identifying restrictions that are based on the cyclical behavior of prices.
Using postwar quarterly data for the Group of Seven, this paper confirms recent evidence that the price level is countercyclical. The quantitative results are affected by the choice of the detrending procedure but the hypothesis of countercyclical price behavior is supported in most cases. The key finding of this paper is that the inflation rate, by contrast, is generally positively correlated with various measures of the cyclical component of output. The results are again sensitive to the choice of the procedure for detrending output, but the finding of procyclical variation of inflation holds in most cases for the Group of Seven.
This paper also examines the cyclical behavior of prices and inflation using the unemployment rate as an alternative indicator of the cycle. The cyclical component of unemployment is shown to be negatively correlated with inflation over the postwar period for the Group of Seven, confirming that inflation moves procyclically. However, the evidence on the countercyclical behavior of the price level is much less robust using this indicator of the cycle.
These findings suggest that the cyclical behavior of the price level and inflation do not provide conclusive grounds for rejecting either demand-determined or supply-determined models of the cycle. The results show the importance of making a clear distinction between inflation and the cyclical component of the price level when reporting and interpreting stylized facts regarding business cycles.