Inflation and Price Setting in a Natural Experiment

We analyze the behaviour of prices using a large disaggregated data set for Poland during transition from a planned to a market economy. The size of price changes and the frequency of adjustment both fall as the inflation rate declines. Price setters follow a mixture of state- and time-contingent policies. We find that price setters are forward-looking. Intermarket price variability increases with inflation and the effect of expected inflation is much stronger than the effect of unexpected inflation. So the bottom line is this: it takes sellers of sausage, eggs, toothpaste, vacuum cleaners, car-wash operators etc. just a few years to figure out how to adjust prices in a market environment. Our results support both the menu cost, and the rational expectations, hypotheses.