DETERMINANTS OF INFLATION IN ROMANIA Student: COVRIG NICOLAE Supervisor: Prof. MOISĂ ALTĂR

Determinants of Inflation in Romania DOFIN, Bucharest, June The facts... Inflation in CEE transition economies (annual percentage change)

Determinants of Inflation in Romania DOFIN, Bucharest, June The goals... To find out the causes of high and persistent inflation in ROMANIA To asses the role of monetary and other economic policies in the disinflation process

Determinants of Inflation in Romania DOFIN, Bucharest, June Possible explanations... Supply or cost-push pressures »wages »currency depreciation Demand-pull factors »monetary expansion to finance fiscal deficits »large nonsterilized capital inflows Structural changes or rigidities »price deregulations »relative price changes

Determinants of Inflation in Romania DOFIN, Bucharest, June …and answers for Romania case The most important factors in driving inflation are the relative price adjustments and the high volatility of inflation Nominal exchange rate depreciation and the nominal wage increases remain a source of inflationary pressures due to risk of spill-overs The monetary sector of the economy is not an important determinant of inflation There is an important inertia component in the inflation evolution The inflationary expectations can be cut off only through coherent structural policies

Determinants of Inflation in Romania DOFIN, Bucharest, June Modelling Approach MONEY MARKETLABOUR MARKET FOREIGN EXCHANGE MARKET Deviation from long-run equilibrium (lagged one period) VAR MODEL Short term dynamics of endogenous variables RELATIVE PRICE ADJUSTMENTS ADMINISTRATIVE DECISIONS ABOUT PRICES Exogenous variables Cointegration analysis (in level of variables) Sample: 1996:01 – 2002:02 Frequency: monthly

Determinants of Inflation in Romania DOFIN, Bucharest, June LONG RUN EQUILIBRIUM ON THE MONEY MARKET Theoretical consideration (Ericsson 1998) Where: - nominal money demand (in log) - scale variable, GDP for instance (in log) - rate of return on money itself (expressed in level) - rate of return on assets outside of money (expressed in level) - rate of inflation

Determinants of Inflation in Romania DOFIN, Bucharest, June LONG RUN EQUILIBRIUM ON THE MONEY MARKET Choice of variables for Romania case (1/8) Monthly observation for M2XR where M2XR = M2R – resident’s foreign currency deposits M2XR is I(1) Seasonally adjusted time series was use

Determinants of Inflation in Romania DOFIN, Bucharest, June LONG RUN EQUILIBRIUM ON THE MONEY MARKET Choice of variables for Romania case (2/8) THE CHOICE OF M2XRSA WAS JUSTIFIED BY: the strong correlation between M1R and M2XR the intention to capture the monetary substitution the greater volatility in M2XR the avoidance of portfolio reallocation due to financial innovation

Determinants of Inflation in Romania DOFIN, Bucharest, June LONG RUN EQUILIBRIUM ON THE MONEY MARKET Choice of variables for Romania case (3/8) As scale variable we use the volume of industrial production (seasonally adjusted series) LYSA ~ I(1) at 99% To put in evidence the optimal portfolio selection we use: the nominal deposit rate applied by banks to non-bank customers (% per year) DR ~ I(1) at 99% The nominal depreciation of ROL against USD is used as proxy for return of deposits in foreign currencies as principal assets outside the M2XR DLEXUSD ~ I(0) or I(1) taking into account the structural break

Determinants of Inflation in Romania DOFIN, Bucharest, June LONG RUN EQUILIBRIUM ON THE MONEY MARKET Johansen cointegration analysis (4/8) REMARK: DUMMY9703 included – cointegration test possibly affected 2 LAGS IN VAR

Determinants of Inflation in Romania DOFIN, Bucharest, June LONG RUN EQUILIBRIUM ON THE MONEY MARKET Johansen cointegration analysis (5/8) LM2XRSAYSADRDLEXUSDIntercept Unrestricted cointegrating coefficients for: Normalized cointegrating coefficients for: ( ) [ ] ( ) [ ] ( ) [ ] ( ) [ ] Adjustment coefficient for

Determinants of Inflation in Romania DOFIN, Bucharest, June LONG RUN EQUILIBRIUM ON THE MONEY MARKET Johansen cointegration analysis (6/8)

Determinants of Inflation in Romania DOFIN, Bucharest, June LONG RUN EQUILIBRIUM ON THE MONEY MARKET Statistics for Johansen cointegration analysis (7/8)

Determinants of Inflation in Romania DOFIN, Bucharest, June LONG RUN EQUILIBRIUM ON THE MONEY MARKET Error correction term (8/8) The large disequilibria are strongly related to the nominal exchange rate depreciations and to the nominal deposit rate increase MODELLING APPROACH

Determinants of Inflation in Romania DOFIN, Bucharest, June LONG RUN EQUILIBRIUM ON THE LABOUR MARKET Theoretical consideration Real wage W/P is a mark-up over the labour productivity LP where and P – level of price E - employment W – net nominal wage Y - output

Determinants of Inflation in Romania DOFIN, Bucharest, June LONG RUN EQUILIBRIUM ON THE LABOUR MARKET Variable evolution ALL VARIABLES ARE I(1)

Determinants of Inflation in Romania DOFIN, Bucharest, June LONG RUN EQUILIBRIUM ON THE LABOUR MARKET Johansen cointegration test REMARK: SEASONAL CENTERED DUMMIES WERE INCLUDED DUMMYDEC and DUMMYJAN; 10 LAGS IN VAR

Determinants of Inflation in Romania DOFIN, Bucharest, June LONG RUN EQUILIBRIUM ON THE LABOUR MARKET Johansen cointegration test VariableLWAGRLLPLMARKUPTrendIntercept Normalized adjustment coefficient for: [ ] [ ] [ ] Normalized cointegrating coefficients for: [ ] [ ] [ ]

Determinants of Inflation in Romania DOFIN, Bucharest, June LONG RUN EQUILIBRIUM ON THE LABOUR MARKET Additional statistics

Determinants of Inflation in Romania DOFIN, Bucharest, June LONG RUN EQUILIBRIUM ON THE LABOUR MARKET Additional statistics

Determinants of Inflation in Romania DOFIN, Bucharest, June LONG RUN EQUILIBRIUM ON THE LABOUR MARKET Error correction term (8/8) MODELLING APPROACH

Determinants of Inflation in Romania DOFIN, Bucharest, June RELATIVE PRICE ADJUSTMENTS (1/7) Theoretical considerations Ball and Mankiw (1995) offer sound justification for including skewness of the distribution of relative price changes as an explanatory variable for inflation Ball and Mankiw (1994) explain the mechanism through which inflation is influenced by the variance of the shocks Reasons for asymmetric, relative price adjustments - the cost-recovery hypothesis - relative wages of high-skilled workers may be slow to adjust to equilibrium - insufficient adjustment of measured prices for quality improvements - the Balassa-Samuelson effects assymetric shocks are very important trend inflation is very important

Determinants of Inflation in Romania DOFIN, Bucharest, June RELATIVE PRICE ADJUSTMENTS (2/7) 35 classes of goods and services in the CPI structure

Determinants of Inflation in Romania DOFIN, Bucharest, June RELATIVE PRICE ADJUSTMENTS (3/7)

Determinants of Inflation in Romania DOFIN, Bucharest, June RELATIVE PRICE ADJUSTMENTS (4/7) Highest price changes between 1997 and 2002 Smallest price changes between 1997 and 2002

Determinants of Inflation in Romania DOFIN, Bucharest, June RELATIVE PRICE ADJUSTMENTS (5/7)

Determinants of Inflation in Romania DOFIN, Bucharest, June RELATIVE PRICE ADJUSTMENTS (6/7) High skewned distribution

Determinants of Inflation in Romania DOFIN, Bucharest, June RELATIVE PRICE ADJUSTMENTS (7/7) MODELLING APROACH

Determinants of Inflation in Romania DOFIN, Bucharest, June ADMINISTRATED PRICES Twelve month percentage change

Determinants of Inflation in Romania DOFIN, Bucharest, June ADMINISTRATED PRICES “Net inflation” (1)

Determinants of Inflation in Romania DOFIN, Bucharest, June ADMINISTRATED PRICES “Net inflation” (2)

Determinants of Inflation in Romania DOFIN, Bucharest, June Autonomous inflation: 27,99 % per annum Inflation inertia: 0.19 ADMINISTRATED PRICES “Net inflation” (3)

Determinants of Inflation in Romania DOFIN, Bucharest, June ADMINISTRATED PRICES “Net inflation” (4) MODELLING APPROACH

Determinants of Inflation in Romania DOFIN, Bucharest, June SHORT RUN DYNAMICS OF INFLATION (1/7) Unrestricted vector autoregression with one lag and: –Endogenous variables : DLCPI (inflation rate) DLM2XR (the change in real M2XR) DLEXUSDR (real depreciation of ROL against USD) –Exogenous variables: ECTMONEY(-1) (error correction term for real money) ECTWAGE (-2) (error correction term for real wages) WSKEW (weighted skewness of price changes) WSTDEV (weighted standard deviation of price changes) DUMMY9605, DUMMY9612, DUMMY9701, DUMMY9905

Determinants of Inflation in Romania DOFIN, Bucharest, June SHORT RUN DYNAMICS OF INFLATION (2/7)

Determinants of Inflation in Romania DOFIN, Bucharest, June SHORT RUN DYNAMICS OF INFLATION (3/7)

Determinants of Inflation in Romania DOFIN, Bucharest, June SHORT RUN DYNAMICS OF INFLATION (4/7) Impulse response function

Determinants of Inflation in Romania DOFIN, Bucharest, June SHORT RUN DYNAMICS OF INFLATION (5/7) Variance decomposition

Determinants of Inflation in Romania DOFIN, Bucharest, June SHORT RUN DYNAMICS OF INFLATION (6/7) Parsimonious model

Determinants of Inflation in Romania DOFIN, Bucharest, June SHORT RUN DYNAMICS OF INFLATION (7/7) Parsimonious model

Determinants of Inflation in Romania DOFIN, Bucharest, June Conclusion and policy implications (1/2) The most important factors in driving inflation are the relative price adjustments and the high volatility of inflation The relative price adjustment process was necessary large shocks induced in the overall price system by energy price changes the persistence of inflation and the relative price adjustment process increase the variability of inflation Nominal exchange rate depreciation generates inflation by: The price of raw material products imported The Balassa-Samuelson effect The nominal wages increases remain a source of inflationary pressures due to risk of spill-overs However, in the next period the real wages evolution will not be an inflationary source

Determinants of Inflation in Romania DOFIN, Bucharest, June Conclusion and policy implications (2/2) The monetary sector of the economy is not an important determinant of inflation The monetary policy has been enough tight during the period analysed There is an important inertia component in the inflation evolution The role of inflation expectation The inflationary expectations can be cut off only through coherent structural policies

Determinants of Inflation in Romania DOFIN, Bucharest, June The facts... Consumer Price Index (average annual change in %) Romania Poland Hungary Czech Republic Slovakia Bulgaria