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DOFIN
ACADEMY OF ECONOMIC STUDIES BUCHAREST
DOCTORAL SCHOOL OF FINANCE AND BANKING
INFLATION PERSISTENCE IN NEW EU
MEMBER STATES:IS IT DIFFERENT THAN IN
THE EURO AREA MEMBERS?
Student: Maria Cristina Popa
Supervisor: Professor Moisa Altar
12.07.2008
Bucharest
July 2008
Contents
1
3
2
3
4
5
3
6
7
3
12.07.2008
Objectives for this paper
Inflation persistence and its importance
Literature Review
The model: New Hybrid Phillips Curve
Empirical methodology
Data, Estimations and Results
Conclusions
Objectives
To estimate the New Hybrid Phillips Curve
for selected new member states (Slovak
Republic, Czech Republic, Poland,
Hungary and Romania) as a measure of
inflation persistence
To compare the results with those
available in GGL (2001) for the Euro Area
To compare the nature of Romanian
inflation with that reported for other
economies
12.07.2008
Inflation persistence and its importance (1)
Over the medium to long run - inflation is a monetary
phenomenon entirely determined by monetary policy
Over shorter horizons various macroeconomic
shocks, including variations in economic activity or
production costs, will temporarily move inflation
away from the central bank’s inflation objective
Inflation persistence refers to the tendency of
inflation to converge slowly towards its long-run
value in response to these shocks
Differences in inflation persistence among the current
Euro Area Members- raised by different studies
starting from 2002.
12.07.2008
Inflation persistence and its importance (2)
For the New Member States inflation persistence can
influence the fulfillment of the Maastricht criteria,
which is an issue before and even after euro adoption
Maastricht criterion on inflation stability says that the
NMS must have inflation comparable to the best
inflation performers
This inherently implies that in the case of common
shocks, the benchmark will be set by countries with a
high speed of inflation adjustment
12.07.2008
Literature review (1)
 Inflation persistence measures are usually based on univariate
models (e.g. the sum of autoregressive coefficients, the largest
autoregressive root, half-life and spectral density at frequency
zero
 Gali and Gertler (1999) - The structural estimates describing
inflation dynamics based on The New Phillips Curve
 Marques (2004) in univariate analysis, the mean of the
inflation process is often assumed to be constant
 Dossche and Everaert (2005) discuss the role of monetary
policy changes for the inflation mean.
 Darvas and Varga (2007)- time varying coefficients to
measure inflation persistence
12.07.2008
Literature review (2)
 In contrast to the traditional Phillips curves, the NPC implies
purely forward looking inflation dynamics
 Extensions to incorporate inflation inertia into the NPC model
resulting the New Hybrid Phillips Curve:
 Gali and Gertler (GG, 1999) estimated the NHPC for the
US
 Gali,Gertler and Lopez Salido (GGL, 2001) for the Euroarea
 Ribon (2004) – for Israel
 Jondeau and Le Bihan (2005)
 Benigno and Lopez-Salido (2006) estimated NKPC for
five major euro-area countries.
12.07.2008
The model: New Hybrid Phillips Curve (1)
 New literature on inflation is built on the work of Fischer
(1977), Taylor (1980) and Calvo (1983) with focus on the
sticky prices and forward-looking behavior framework
 Gali et al. (1999) consider a continuous environment of
monopolistically competitive firms
 Let 1-θ be a random fraction of firms that are going to adjust
their price in any given period
 A fraction ω use a backward looking rule of thumb to set their
prices
 Fraction 1- ω set their price by solving an optimization
problem that leads them to consider the expected future
behavior of marginal costs ( forward looking firms).
12.07.2008
The model: New Hybrid Phillips Curve (2)
^
Let  t  pt  pt 1 denote the inflation rate at t, and mc t
percent deviation of the firms real marginal cost
from its steady state value
There are two approaches where the real marginal
cost is replaced by an appropriate proxy variable:
 output gap
 the real unit labor cost
According to Gali and Gertler’s findings for US,
the output gap as a measure of real activity fails
yielding usually a negative sign and/or being
insignificant.
12.07.2008
The model: New Hybrid Phillips Curve (3)
The inflation process for a closed economy
can be defined as :
~
^
 t   b  t  1   f E t { t  1 }   mc t
~
 
(1   )(1   )(1   )(1   )

,  b    1 , 
     (1   (1   ))
12.07.2008
f
   1 ,
Empirical methodology (1)
Generalized Method of Moments - a feasible
method for the estimation and testing of New
Phillips Curve in different forms
In particular, under the rational expectation
hypothesis, a set of variables is assumed to be
perpendicular to current surprise inflation
GMM is a robust estimator in that, unlike
maximum likelihood estimation, it does not
require the information of the exact
distribution of the disturbances.
12.07.2008
Empirical methodology (2)
The following orthogonality conditions can be
written in order to estimate the model using
GMM:
E[( t   b  t  1   f  t  1  mc t ) Z t ]  0
Where Zt is a vector of instrumental variables that
must be uncorrelated with εt
 t  t  ( t 1  Et  t 1 )
12.07.2008
Empirical methodology (3)
We use instruments dated t-1 or earlier for two
reasons:
 First, there is likely to be considerable error in our measure of
marginal cost. Assuming this error is uncorrelated with past
information, it is appropriate to use lagged instruments.
 Second, not all current information may be available to the public
at the time they form expectations.
Our vector of instrument variables involves five lags
of the GDP deflator, two lags real unit labor costs,
two lags of CPI and wage inflation and four lags of
the t-bill rate.
12.07.2008
Data
Quarterly data are used, covering the main
period 1996Q1: 2007Q4. All data are in
logarithms.
All time series are quarterly and the data are
obtained from Eurostat, International Monetary
Fund International Financial Statistics, OECD,
and NBR:
 infGDP: inflation based in the GDP deflator ; Index number
(2000)
 infCPI: inflation based on HCPI ;Index number (2005)
(Harmonised Consumer Price Index)
 winfl: wage inflation (annualized q-o-q change)
 rulc : real unit labor cost
 tbill: three months t-bill rate
12.07.2008
Data
The inflation rate ( πt ) - the annualized
quarterly percentage change in the implicit
GDP deflator:
 t  400 * ln( Pt / Pt 1 )
,where
is the GDP deflator.
Real unit labor cost (rulc) - deviation of the
log of the income share from its average value:
the labor income share = the ratio of total
compensation of employees in the economy to
nominal GDP.
12.07.2008
Inflation based on the GDP deflator (1)
16
32
28
12
24
20
8
16
12
4
8
4
0
0
-4
-4
96 97 98 99 00 01 02 03 04 05 06 07
96 97 98 99 00 01 02 03 04 05 06 07
GDP_CZ
8
GDP_PL
6
4
2
0
-2
-4
98
12.07.2008
99
00
01
02
03
GDP_HU
04
05
06
07
Inflation based on the GDP deflator (2)
20
16
12
10
8
0
4
0
-10
-4
-20
-8
-12
-30
-16
-40
-20
96 97 98 99 00 01 02 03 04 05 06 07
GDP_SK
12.07.2008
99
00
01
02
03
04
GDP_RO
05
06
07
Results (1)
 1.1 Reduced-form estimates of the NHPC
Parameters
Hungary
Czech Republic
Poland
Romania
Slovak Republic
Euro Area
12.07.2008
Test
γb
γf
λ
J test (p value)
0.362**
0.546*
0.00092
9.076
(0.112)
(0.113)
(0.024)
(0.76)
0.210**
0.540*
0.015
7.59
(0.062)
(0.056)
(0.008)
(0.81)
0.280**
0.610*
0.0017*
3.430
(0.041)
(0.055)
(0.004)
(0.995)
0.262*
0.709*
0.00037
3.96
(0.051)
(0.086)
(0.001)
0.939
0.410*
0.420*
0.037*
7.539
(0.044)
(0.048)
(0.009)
(0.87)
0.272*
0.689*
0.039*
7.485
(0.072)
(0.044)
(0.049)
(0.380)
Results (2)
1.2 Structural estimates of the new
hybrid Phillips curve
Two alternative specifications of the
orthogonality conditions (for the
structural form):
^
Et {( t   t 1   t 1  (1   )(1   )(1   ) mct ) zt }  0,
E t {( t  
12.07.2008
1
 t  1  
1
 t  1  (1   )(1   )(1   )
1
^
mc t ) z t }  0
Results (3)
Parameters
Hungary
Czech Republic
Poland
Romania
Slovak Republic
Euro Area
12.07.2008
Test
θ
ω
β
λ
γb
γf
D
J test (p value)
0.552
0.305
0.741
0.226
0.375
0.503
2.23
6.386
(0.100)
(0.106)
(0.741)
0.608
0.561
1.092
(0.202)
(0.244)
(0.568)
0.290
0.360
0.92*
(0.088)
(0.072)
(0.043)
0.843
0.231
1.000
0.018
(0.031)
(0.061)
(0.013)
(0.06)
0.510
0.630
0.98
0.003
(0.046)
(0.067)
(0.003)
0.706
0.359
0.604
(0.026)
(0.043)
(0.044)
0.907
0.024
0.897
(0.015)
(0.122)
(0.053)
0.922
0.335
0.920
(0.031)
(0.129)
(0.074)
(0.846)
0.048
0.467
0.554
2.55
6.985
(0.600)
0.058
0.561
0.415
1.40
6.590
(0.921)
0.215
0.785
6.38
7.004
(0.598)
0.556
0.440
2.04
7.596
(0.868)
0.035
0.317
0.478
3.33
7.273
(0.887)
0.018
0.877
0.025
10.0
8.428
(0.393)
0.006
0.272
0.689
12.8
7.485
(0.380)
Results (4)
The estimates support the importance of
backward looking price setting behavior in
as measured by the fraction of backward
looking firms, ω
The probability of fixed prices θ is lower
for the NMS than in the Euro Area
12.07.2008
Conclusions
 The backward-looking behavior is stronger than
forward-looking in most of the NMS
 Compared to the Euro area the inflationary
process exhibits in the NMS a higher degree of
inertia equivalent to a higher degree of inflation
persistence
 For Romania, we obtain an almost equal
proportion of backward and forward looking
behavior
 Inflation persistence is an important characteristic
to look at in the process of euro adoption and the
New Hybrid Phillips Curve gives a consistent
measure, which should be taken in consideration.
12.07.2008
DOFIN
12.07.2008