Download inflation targeting and new eu entrants: is there

INFLATION TARGETING AND NEW EU
ENTRANTS: IS THERE MONETARY
UNIFORMITY?
Joseph J. St. Marie
The University of Southern
Mississippi
ABSTRACT
• The four newest entrants into the EU who have
an explicit policy of inflation targeting for their
respective central banks, is there policy
uniformity within this group?
• Slovenia, Latvia, Lithuania, and Slovakia
• This paper seeks to determine if there is a
difference in interest rate targets between the
high income (Slovenia) entrants and lower
income entrants (Latvia, Lithuania, and
Slovakia). The test instrument is the Taylor Rule.
INTRODUCTION
• This paper explores inflation targeting in new
European Unions members.
• Monetary policy uniformity is one of the
economic goals of the EU based upon the utility
of price stability, for all members.
• New members may or may not have policies that
are in accordance with the European Central
Bank.
• This works analyzes new EU member monetary
policy through the benchmark Taylor rule.
The Taylor Rule
John Taylor presents a monetary policy rule that he characterizes as
one, “that captures the spirit of the recent research and which is
quite straightforward” (Taylor 1993). Thus we find the following
formulation and coefficients.
r=p+.5y + .5(p-2) + 2
where
r= the federal funds rate,
p= the rate of inflation over the previous four quarters
y= the percent deviation of real GDP from a target.
That is,
y= 100(Y-Y*)/Y* where
Y= real GDP, and
Y*= is the trend real GDP
THE TAYLOR MODEL
Taylor (1993) observed that the following equation provides a
reasonable approximation for the short term funds rate for United
States.
r = p +.5 y +.5 (p-2) + 2
Where:
r
is the federal funds rate
p
is the rate of inflation over the previous quarters
y
is the percent deviation of real GDP from a target
y = 100(Y-Y*)/Y*
Y
is the real GDP
Y* is the GDP trend (Taylor 1993)
THE ARGUMENT
• Given the evidence that the Taylor rule is a
sufficient benchmark recommendation for
Fed monetary policy we can assume that
the rule will also be as useful if not more
so when used as a benchmark
recommendation for inflation targeting.
THE REFINED MODEL
Other researchers have modified the model by tinkering with the calculations of
inflation rate, interest rates, optimal output, targeted inflation rate, and the inflation
and output gaps (Maria-Dolores 2005). Here the common practice of formulating
Taylor rule models is followed ( Arestis & Chortareas 2006).
rt = β0 + β1rt-1 + β2Inft + β3 OutputGapt + ε
Where
rt
Inft
OUputGapt
is the nominal interest rate
is the inflation rate in time t
is the output gap
In the above formulation the output gap is calculated according to Clarida, Gali &
Gertler (1997), which is different from Maria-Dolores (2005). However, instead of
using the regression trend line the Hodrick-Prescott filter is used. Since direct and
reliable inflation rates are not available the CPI is used as the inflation measure
(Clarida, Gali & Gertler 1997).
DATA
Data for all countries span from 2001:1 to 2006:12. The
Consumer Price Index is used for inflation, which is
obtained from the sources, respectively. The industrial
production index (IPI) is used to represent the output.
The IPI are filtered through the Hodrick-Prescott
procedure to obtain the potential output. The difference
between the de-trended output and the IPI is used as the
output gap.
RESULTS
Inflation
Output Gap
Adjustment rate
Adjusted R2
Country
Latvia
-.003 (.23)
3.309 (2.84) ***
.958 (44.35) ***
Table 1. Policy tools for inflation targeting, output targeting, and interest rate smoothing.
98.47%
Lithuania
.016 (2.48) **
.369 (.73)
.880 (22.66)
92.32%
Slovakia
-.008 (.53)
2.76 (1.19)
.92 (13.48)***
96.73%
Slovenia
-.77 (3.13)**
2.99 (1.07)*
.79 (12.56)***
98.13%
T values are in parentheses. Levels of significant are * <.1, **<.05, ***<.01.
RESULTS
• The inflation targeting coefficient is significant for Lithuania and
Slovenia.
• Only one of the significant variables is negative (Slovenia). Latvia
does not have a significant output gap coefficient but has a highly
significant coefficient for inflation, which indicates that it does target
output.
• Slovenia, is the only country for which both inflation and the output
gap are significant, Slovenia thus does not necessarily support one
tool or the other.
• Overall, the evidence indicates that Lithuania is targeting inflation,
while Latvia is targeting output.
• The case of Slovenia is mixed as both coefficients are significant.
Some researchers compare the magnitude of the coefficients to
determine the orientation of policy. Based on this interpretation
Slovenia becomes an output targeting nation.
RESULTS II
• Only Slovakia has coefficients that are insignificant.
• The coefficient for adjustment rate for the countries with a coefficient
larger than one are very close to one (1) and the differences (all less
than .026) is due to random error.
• A similar argument applies to Latvia, whose value is just under one
(1), albeit the gap is higher. Therefore, in Latvia the adjustments to
interest rates are done instantaneously and without delay.
• A common factor among all these countries is high values of the
adjusted R-Squared.
CONCLUSIONS
• Small open economies can target output as in
the case of Latvia.
• Slovenia seems to have a mixed targeting
mechanism
• A mixed mechanism would be indicative of the
“two pillar” strategy used by the ECB to
determine monetary policy.
• Recently independent countries like Slovenia
are using similar factors as developed nations to
determine monetary policy.