Evidence on the functional form of inflation and output growth variability relationship in European economies

A bulk of literature reports positive and significant link between inflation and relative price variability (RPV). Monetarists hold that this positive connection between the two variables exerts huge welfare consequences due to the fact that a high RPV increases output dispersion among firms. Some recent studies, however, show that the inflation–RPV nexus is neither linear nor stable over-time and thereby the inflation effects on output dispersion, appearing through this channel, should be minor. To address these ambiguities, this study directly tests the effect of inflation on output growth variability using a large panel of 25 developed and emerging European economies. Moreover, we also probe into the functional form of this nexus by employing a panel smooth transition regression model. Our results support a nonlinear relationship between the two variables and advance certain inflation thresholds below which inflation appeases the sectoral output growth variability and above this level it aggravates the later.