1. MODELLING INFLATION IN CROATIA TANJA BROZ & MARUŠKA VIZEK

2. Structure of the presentation Motivation for the research Short overview of past inflation behaviour in Croatia Review of related work on modelling inflation Derivation of the long-run sectoral determinants of inflation Derivation of short-run inflation model Concluding remarks

3. Motivation for the research Constructing a structural model of inflation in Croatia Encompassing all relevant sectors of the economy Knowing inflation drivers is of the most essential importance for fulfilment of the Maastricht convergence criteria Previous research obscure

4. Past inflation behaviour 1990 – 1993; hyperinflation and recession (1616% yoy) 1993; introduction of the Stabilization program based on nominal exchange rate anchor 1994 – today; stable inflation

5. Related research Payne (2002) – VAR - wage increase and currency depreciation are positively correlated with inflation rates; despite hyperinflation no evidence of inflation inertia. Botrić and Cota (2006) – SVAR - terms of trade and balance of payments shocks have the strongest impact on prices; Croatia is a small open economy with high import dependency and uncompetitive economic structure. Pufnik and Kunovac (2006) - seasonal ARIMA - aggregating CPI component forecasts outperform both the overall CPI and random walk inflation forecasts.

6. Long-run determinants – Markup (1) Assuming one cointegrating vector and linear homogeneity, the derived long run markup relationship becomes: Share of unit labour cost in total unit cost (0.54) seems reasonable since Croatian economy is dominated by service sector. Large share of import prices in total unit cost is due to high import dependency of Croatian economy.

7. Long-run determinants – Markup (2) High correlation with the business cycle

8. Long-run determinants - Excess money (1) Cointegrating vector includes M 1, CPI, GDP, real estate prices, money market rate, interest rate on foreign exchange deposits and a trend

9. Long-run determinants - Excess money (2) Excess money exhibits counter-cyclical properties

10. Long-run determinants – NEER By visual inspection only, the presence of B-S effect could not be confirmed. Hence for short-run inflation function only the first differences of kuna nominal effective exchange rate is used.

11. Long-run determinants – Excess demand

12. Inflation function (1) We regressed Dcpi t on – long run solutions – markup t-1, excessmoney t-1, DNeer t-i, and Dgdp_gap t-i, and –short run dynamics Dppi t-i, Dtrading_partners_cpi t-i, Dm1 t-i, Dimport_prices t-i, Dr_forex t-i, where i takes 1 to 3

13. Inflation function (2) The model passes various diagnostic tests, encompassed the unrestricted general model, variables are statistically significant and have theoretically plausible signs (except nominal effective exchange rate).

14. Inflation function (3) Diagnostic features of the inflation model

15. Inflation function (4) Recursive Analysis of Inflation Model

16. Inflation function (5) Recursively estimated coefficients of the inflation model

17. Concluding remarks All long run relationships significantly influence quarter-on-quarter inflation rate. Markup and excess money, imposed as error correction terms are the most significant variables for explaining the short run behaviour of inflation. Price and monetary variables are found to be important in explaining inflation variance. Magnitude of monetary aggregates influence on CPI is marginal. Pass-through of Croatian trading partners CPI and Croatian PPI on inflation in Croatia are not significant. Presented diagnostic tests suggest that the model could be used for forecasting purposes.