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 Bucharest July 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

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

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.

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

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

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.

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).

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.

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

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.

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

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.

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

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.

Inflation based on the GDP deflator (1)

Inflation based on the GDP deflator (2)

Results (1)  1.1 Reduced-form estimates of the NHPC ParametersTest γbγb γfγf λ J test (p value) Hungary 0.362**0.546* (0.112)(0.113)(0.024)(0.76) Czech Republic 0.210**0.540* (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* (0.051)(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)

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

Results (3) ParametersTest θωβλ γbγb γfγf DJ test (p value) Hungary (0.100)(0.106)(0.741)(0.846) (0.202)(0.244)(0.568)(0.600) Czech Republic * (0.088)(0.072)(0.043)(0.921) Poland (0.031)(0.061)(0.013)(0.06)(0.598) Romania (0.046)(0.067)(0.003)(0.868) Slovak Republic (0.026)(0.043)(0.044)(0.887) Euro Area (0.015)(0.122)(0.053)(0.393) (0.031)(0.129)(0.074)(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

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.

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