Economics Letters 7 (1981) 131-137 North-Holland Publishing Company I31 INFLATION AND RELATIVE PRICES zyxwvutsrqponmlkjihgfedcbaZYXWVUTSRQP A System- Wide Approach * Kenneth W. CLEMENTS Unrwrsity of Western Au~truliu, Nedlunds 6009, Australia Phuong NGUYEN Electro!ytic Zinc Compuny of Austrcrliu, Ltd., Australirr Received I4 May 1981 The paper introduces a system-wide model for the analysis of the effects of inflation on relative prices. This enables the identification of those commodities whose relative prices are distorted by inflation. The model provides measures of the natural rate of relative price variability, which is associated with zero inflation, and the inflation rate which minimizes relative price variability. An illustrative application with Australian data is provided. 1. Introduction A very simple view of inflation is that all prices rise equiproportion- ally. Recent, however, it has been shown that this view is not consistent with the evidence from several countries. ’ It has been found that inflation proceeds in a ragged manner with some prices rising by more than average and others by less. This finding is extremely important because this relative price distortion may cause costly resource realloca- tions, which would have to be included in any evaluation of the cost of inflation. The objective of this paper is to extend the existing analysis by * We would like to acknowledge helpful discussions with and comments by John Andersen, Palle Anderson, Victor Argy, Jeff Carmichael, Jacob Frenkel, Viv Hall, Bob Hawkins, Ephraim Kleiman, Ulrich Kohli, Bill Norton and Henry Theil. ’ See Balk (I 978), Kleiman (1977), Parks (I 978), and Vining and Elwertowski (I 976); see also Fama and Schwert (1979). For related cross-country studies, see Foster (1978), Glejser (1965), Gordon (1971), Jaffee and Kleiman (1977), Logue and Willett (1976), and Okun (1971). 0165-1765/81/0000-0000/$02.50 0 1981 North-Holland