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The Granular Origins of Inflation: How 41% of Inflation Variance in Advanced Economies Is Driven by Individual Firms – Inflation is often viewed as a macroeconomic phenomenon shaped by broad forces like monetary policy, supply chain disruptions, or global demand shocks.

However, groundbreaking research from Santiago Alvarez-Blaser, Raphael Auer, Sarah M. Lein, and Andrei A. Levchenko reveals that individual firms and product categories play a far more significant role in driving inflation than previously understood .

Their study, titled “The Granular Origins of Inflation,” uses barcode-level price data for 16 advanced and emerging market economies over the period 2005–2022 to uncover how granular shocks at the firm level account for 41% of inflation variance in advanced economies .

This research not only challenges traditional views of inflation but also highlights the importance of understanding microeconomic dynamics in shaping aggregate economic outcomes. Let’s dive into the numbers and implications.

Key Findings: Numbers That Tell the Story

1. 41% of Inflation Variance in Advanced Economies

The study shows that firm-specific granular residuals account for 41% of the variance in overall inflation in advanced economies. This means that idiosyncratic shocks to individual firms—such as pricing decisions by large corporations—play a critical role in driving inflation trends.

2. 15% Contribution from Product Categories

Beyond firms, product categories contribute an additional 15% to inflation variance . For example, price changes in categories like “Fruit Juice” or “Breakfast Cereals” can have a measurable impact on aggregate inflation.

3. Post-COVID Inflation Surge

During the 2021–2022 inflation surge , the importance of granular components increased significantly. The firm-level component accounted for roughly one-third (38%) of inflation in advanced economies , up from 22% in the pre-pandemic period.

4. Top 10 Firms Dominate Market Shares

The study highlights that the top 10 largest firms account for 41% of overall sales in an average country, underscoring the concentration of market power and its potential to influence inflation.

5. Emerging Markets Show Less Granularity

In contrast, emerging markets exhibit less granularity. Here, granular residuals account for only 20% of inflation variance , as higher average inflation rates tend to overshadow idiosyncratic shocks.

6. Retailers Play a Role

When considering the retail dimension, retailer granular residuals account for 17% of inflation variance in advanced economies and 14% in emerging markets.

Why Does Granularity Matter?

Granularity matters because it challenges the traditional view that inflation is solely driven by macroeconomic shocks. Instead, idiosyncratic shocks to large firms and product categories can amplify or dampen inflationary pressures . For instance

• Larger firms are more sensitive to common shocks , such as global supply chain disruptions, which became evident during the post-COVID inflation surge.
• Idiosyncratic shocks —like a major retailer raising prices due to rising input costs—can ripple through the economy and contribute to aggregate inflation.

Implications for Policymakers

The findings have important implications for central banks and policymakers

1. Focus on Large Firms :
   Since large firms disproportionately influence inflation, monitoring their pricing behavior could provide early warnings of inflationary pressures.
2. Tailored Policies :
   Policymakers may need to design targeted interventions to address sector-specific inflation drivers, rather than relying solely on broad monetary tools.
3. Global Supply Chains :
   The heightened sensitivity of large firms to global shocks underscores the importance of stabilizing international supply chains to mitigate inflation risks.

The Role of Retailers

The study also explores the role of retailers in inflation dynamics. While retailer data is less comprehensive, especially in emerging markets, the analysis finds that:

• Retailer granular residuals account for 17% of inflation variance in advanced economies .
• This highlights the importance of large retail chains in shaping price trends, particularly in concentrated markets.

Decomposing Granular Residuals

The researchers further decompose the granular residuals into two components:

1. True Idiosyncratic Shocks :
   These are unique to individual firms or product categories and are not driven by broader macroeconomic factors. For the firm granular residual, true idiosyncratic shocks account for 35 percentage points out of the total 41% variance share .
   
2. Differential Responses to Common Shocks :
   Larger firms or categories may respond differently to common shocks, such as changes in input costs or exchange rates. For the category granular residual, differential responses account for 9 percentage points out of the total 15% variance share .

Cross-Country Differences

The importance of granular residuals varies across countries:

• Market Concentration :
  Granular residuals are more significant in economies with concentrated market shares. For example, the top 10 firms account for 60% of sales in Mexico, compared to just 17% in Russia.
• Inflation Rates :
  In high-inflation environments like emerging markets, macro shocks dominate inflation dynamics , with granular residuals accounting for only 20% of variance.

Post-COVID Inflation Surge

The study documents a notable increase in the importance of granular components during the 2021–2022 inflation surge :

• In advanced economies, the firm granular component contributed 1.47 percentage points to the 3.91% average inflation rate .
• In emerging markets, granular components accounted for 1.13 percentage points of a total average inflation of 10.56% .

This suggests that the post-pandemic inflation surge was partly driven by granular forces , particularly in advanced economies.

Conclusion

The granular origins of inflation reveal that inflation is not just a macroeconomic story—it’s also a microeconomic one.

By understanding the role of individual firms and product categories, we gain deeper insights into the dynamics of inflation and how to manage it effectively.

As the post-COVID era has shown, granular forces can drive significant inflation surges , making them a critical area of focus for future research and policy.

Related articles

https://www.nber.org/papers/w33404

https://mgiedit.org/digitalization-on-global-trade-patterns/