1. DOFIN 12.07.2008 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 Bucharest July 2008

2. 12.07.2008 Contents Inflation persistence and its importance 2 The model: New Hybrid Phillips Curve 4 Objectives for this paper 31 Literature Review 33 Data, Estimations and Results 6 Conclusions 37 Empirical methodology 35

3. 12.07.2008 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

4. 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.

5. 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

6. 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

7. 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 Euro- area  Ribon (2004) – for Israel  Jondeau and Le Bihan (2005)  Benigno and Lopez-Salido (2006) estimated NKPC for five major euro-area countries.

8. 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).

9. 12.07.2008 The model: New Hybrid Phillips Curve (2)  Let denote the inflation rate at t, and 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.

10. 12.07.2008 The model: New Hybrid Phillips Curve (3)  The inflation process for a closed economy can be defined as :

11. 12.07.2008 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. 12.07.2008 Empirical methodology (2)  The following orthogonality conditions can be written in order to estimate the model using GMM:  Where Z t is a vector of instrumental variables that must be uncorrelated with ε t

13. 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.

14. 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:  inf GDP : inflation based in the GDP deflator ; Index number (2000)  inf CPI : 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

15. 12.07.2008 Data  The inflation rate ( π t ) - the annualized quarterly percentage change in the implicit GDP deflator:, 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.

16. 12.07.2008 Inflation based on the GDP deflator (1)

17. 12.07.2008 Inflation based on the GDP deflator (2)

18. 12.07.2008 Results (1)  1.1 Reduced-form estimates of the NHPC ParametersTest γbγb γfγf λ J test (p value) Hungary 0.362**0.546*0.000929.076 (0.112)(0.113)(0.024)(0.76) Czech Republic 0.210**0.540*0.0157.59 (0.062)(0.056)(0.008)(0.81) Poland 0.280**0.610*0.0017*3.430 (0.041)(0.055)(0.004)(0.995) Romania 0.262*0.709*0.000373.96 (0.051)(0.086)(0.001)0.939 Slovak Republic 0.410*0.420*0.037*7.539 (0.044)(0.048)(0.009)(0.87) Euro Area 0.272*0.689*0.039*7.485 (0.072)(0.044)(0.049)(0.380)

19. 12.07.2008 Results (2) 1.2 Structural estimates of the new hybrid Phillips curve  Two alternative specifications of the orthogonality conditions (for the structural form):

20. 12.07.2008 Results (3) ParametersTest θωβλ γbγb γfγf DJ test (p value) Hungary0.5520.3050.7410.2260.3750.5032.236.386 (0.100)(0.106)(0.741)(0.846) 0.6080.5611.0920.0480.4670.5542.556.985 (0.202)(0.244)(0.568)(0.600) Czech Republic0.2900.3600.92*0.0580.5610.4151.406.590 (0.088)(0.072)(0.043)(0.921) Poland0.8430.2311.0000.0180.2150.7856.387.004 (0.031)(0.061)(0.013)(0.06)(0.598) Romania0.5100.6300.980.0030.5560.4402.047.596 (0.046)(0.067)(0.003)(0.868) Slovak Republic0.7060.3590.6040.0350.3170.4783.337.273 (0.026)(0.043)(0.044)(0.887) Euro Area0.9070.0240.8970.0180.8770.02510.08.428 (0.015)(0.122)(0.053)(0.393) 0.9220.3350.9200.0060.2720.68912.87.485 (0.031)(0.129)(0.074)(0.380)

21. 12.07.2008 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

22. 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.

23. DOFIN 12.07.2008