1. The role of inflation expectations in the New EU Member States Student: DORINA COBÎSCAN Supervisor: PhD. Professor MOISĂ ALTĂR Bucharest, 2010 THE ACADEMY OF ECONOMIC STUDIES BUCHAREST DOCTORAL SCHOOL OF FINANCE AND BANKING

2. Topics The importance of inflation expectations Objectives Quantification of inflation expectations The VAR model with exogenous variables Testing rationality Conclusions

3. The importance of inflation expectations Inflation expectations is one of the most important channels through which monetary policy affects economic activity. It is important in process of price formation. Quantification of inflation expectations play an important role for a central bank which adopted strategy of inflation targeting. It reflects the credibility of population in the central bank. Understanding the nature of inflation expectations help central banks to assure a price stability.

4. Objectives  To quantify inflation expectations in the New EU Member States (Czech Republic, Hungary, Poland and Romania)  To find out if a chosen distribution function influences the results of inflation expectations  To indentify the relationship between inflation expectation and actual inflation  To identify the nature of inflation expectations in the New EU Member States

5. Quantification of inflation expectations (1) Consumer survey carried out by the European Commission Monthly data Sample size : 1000 respondents for Czech Republic, Poland, Romania and 1500 respondents for Hungary Sample period: 2001 M05 – 2010 M02 Data:

6. Quantification of inflation expectations (2) Questions 5 and 6 of consumer survey Question 5: How do you think that consumer prices have developed over the last 12 months? a) risen a lot b) risen moderately c) risen slightly d) stayed about the same e) fallen f) don't know Question 6: By comparison with the past 12 months, how do you expect that consumer prices will develop in the next 12 months? They will… a) increase more rapidly b) increase at the same rate c) increase at a slower rate d) stay about the same e) fall f) don't know

7. Quantification of inflation expectations (3) 1. Balance statistics: BS = 1∙a+ ½∙ b - ½∙ d-1∙e

8. Quantification of inflation expectations (4) 2. Normal distribution – adjusted Carlson-Parkin method Source: Batchelor, Orr, 1988

9. Quantification of inflation expectations (5) Making the the necessary transformations, the following results are obtained:

10. Quantification of inflation expectations (6) Quantification of perceived inflation: (10) Where Assumptions for estimating moderate inflation: The average value of actual inflation rate over the whole sample; The running mean of actual inflation; A linear interpolation between the average of the first half of the sample and the average of the second half of the sample; Respondents do not make systematic errors; Moderate inflation changes linearly and it is needed to quantify the moderate inflation in order to minimize the sum of the square differences between actual and quantified perceived inflation.

11. Quantification of inflation expectations (7) Quantification of inflation expectations and perceived inflation

12. Quantification of inflation expectations (7) 3. Uniform distribution – adjusted method The solutions of the equations is as follows: Source: Lyziak (2003)

13. Quantification of inflation expectations (7) Quantification of inflation expectations using normal and uniform distribution function

14. The VAR model with exogenous variables (1) Data description: The analysis is based on monthly data covering the period 2001M05-2009M9. All time series are monthly and the data are obtained from Eurostat, NBR, NBP, MNB, CNB, INSSE. The VAR model has following endogenous variables:  CORE denotes HICP excluding unprocessed food and energy components, 2005=100;  EXP denotes inflation expectations relative to perceived inflation;  GAP is the output gap.The series was determined by applying Hodrick-Prescott Filter to monthly real GDP series. The monthly data were calculated by interpolating the quarterly seasonally adjusted real GDP data (expressed in national currency) in logarithm through Chow-Lin method using as indicator variable the industrial production; - and exogenous variables:  OIL is the Brent crude oil price in domestic currency, which is calculated as the price of the oil (in US dollars) multiplied with the monthly average of the exchange rates between national currencies and the US dollars;  PPI_EU is the PPI in the EU-27, 2005=100;  FOOD is the producer price index of the domestic food industry, 2005=100;  ENERGY is the producer price index of energy sector, 2005=100;  I_EUR_3M is EURIBOR 3-month money market rate, %.

15. The VAR model with exogenous variables (2) The Augment Dickey-Fuller test results show that all variables are stationary. Note that some of the variables were transformed logarithmically (L) or/and for others the first difference (D) was taken. According to Schwarz and Hannan-Quinn information criteria, the VAR models includes 1 lag.

16. The VAR model with exogenous variables (3) Impulse response function and variance decomposition – the case of Romania

17. The VAR model with exogenous variables (4) Impulse response function and variance decomposition – the case of Hungary

18. The VAR model with exogenous variables (5) Impulse response function and variance decomposition – the case of Poland

19. The VAR model with exogenous variables (6) Impulse response function and variance decomposition – the case of Czech Republic

20. Testing rationality (1) Testing the homogeneity of different demographic groups:

21. Testing rationality (2) Rationality test is given by the equation: Where π t is the inflation at time t and π t e is the expected inflation for time t. If the inflation expectations are rational: α must be equal to zero and β must be equal to one.

22. Conclusions: Obtained results using Carlson-Parkin approach show that: 1.Inflation expectations and perceived inflation are correlated with actual inflation 2.However there are some periods of misperception due to factors like adhering to the EU or global crisis. 3.Chosen distribution functions in our studies do not influences the results of inflation expectations 4.VAR models depicts that only in case of Romania and Czech Republic exists a relationship between inflation expectations and inflation ( expectations influence actual inflation).

23. 5. In case of Hungary and Poland, national banks succeeded to break the link between inflation and inflation expectations 6.In the case of Romania and Hungary, the group of respondents divided by level of education is heterogeneous – expected inflation decrease once the level of education is higher 7.In case of Hungary inflation expectations decrease once the level of income increases – group divided by the level of income is heterogeneous 8.For full sample, only in case of Czech Republic and Poland inflation expectations are rational

24. Thank you!