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DETERMINANTS OF INFLATION IN ROMANIA. Student: COVRIG NICOLAE Supervisor: Prof. MOIS Ă ALTĂR. The facts . I nflation in CEE transition economies (annual percentage change). The goals. To find out the causes of high and persistent inflation in ROMANIA

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determinants of inflation in romania

DETERMINANTS OF INFLATION IN ROMANIA

Student: COVRIG NICOLAE

Supervisor: Prof. MOISĂ ALTĂR

the facts
The facts ...

Inflation in CEE transition economies (annual percentage change)

DOFIN, Bucharest, June 2002

the goals
The goals...
  • To find out the causes ofhigh and persistent inflation in ROMANIA
  • To asses therole of monetary and other economic policies in the disinflation process

DOFIN, Bucharest, June 2002

possible explanations
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

DOFIN, Bucharest, June 2002

and answers for romania case
…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

DOFIN, Bucharest, June 2002

modelling approach

Cointegration analysis (in level of variables)

MONEY MARKET

LABOUR MARKET

Deviation from long-run equilibrium

(lagged one period)

VAR MODEL

Short term dynamics of endogenous variables

FOREIGN EXCHANGE MARKET

RELATIVE PRICE ADJUSTMENTS

ADMINISTRATIVE DECISIONS ABOUT PRICES

Exogenous variables

ModellingApproach

Sample: 1996:01 – 2002:02

Frequency: monthly

DOFIN, Bucharest, June 2002

long run equilibrium on the money market theoretical consideration ericsson 1998
LONG RUN EQUILIBRIUM ON THE MONEY MARKETTheoretical 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

DOFIN, Bucharest, June 2002

long run equilibrium on the money market choice of variables for romania case 1 8
LONG RUN EQUILIBRIUM ON THE MONEY MARKETChoice of variables for Romania case (1/8)

Monthly observation for M2XR where

M2XR = M2R – resident’s foreign

currency deposits

Seasonally adjusted time series was use

M2XR is I(1)

DOFIN, Bucharest, June 2002

long run equilibrium on the money market choice of variables for romania case 2 8
LONG RUN EQUILIBRIUM ON THE MONEY MARKETChoice 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

DOFIN, Bucharest, June 2002

long run equilibrium on the money market choice of variables for romania case 3 8
LONG RUN EQUILIBRIUM ON THE MONEY MARKETChoice 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

DOFIN, Bucharest, June 2002

long run equilibrium on the money market johansen cointegration analysis 4 8
LONG RUN EQUILIBRIUM ON THE MONEY MARKETJohansen cointegration analysis (4/8)

REMARK: DUMMY9703 included – cointegration test possibly affected

2 LAGS IN VAR

DOFIN, Bucharest, June 2002

long run equilibrium on the money market johansen cointegration analysis 5 8
LONG RUN EQUILIBRIUM ON THE MONEY MARKETJohansen cointegration analysis (5/8)

DOFIN, Bucharest, June 2002

long run equilibrium on the money market johansen cointegration analysis 6 8
LONG RUN EQUILIBRIUM ON THE MONEY MARKETJohansen cointegration analysis (6/8)

DOFIN, Bucharest, June 2002

long run equilibrium on the money market statistics for johansen cointegration analysis 7 8
LONG RUN EQUILIBRIUM ON THE MONEY MARKETStatistics for Johansen cointegration analysis (7/8)

DOFIN, Bucharest, June 2002

long run equilibrium on the money market error correction term 8 8
LONG RUN EQUILIBRIUM ON THE MONEY MARKETError 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

DOFIN, Bucharest, June 2002

long run equilibrium on the labour market theoretical consideration
LONG RUN EQUILIBRIUM ON THE LABOUR MARKETTheoretical consideration

Real wage W/P is a mark-up over the labour productivity LP

and

where

P – level of price E - employment

W – net nominal wage Y - output

DOFIN, Bucharest, June 2002

long run equilibrium on the labour market variable evolution
LONG RUN EQUILIBRIUM ON THE LABOUR MARKETVariable evolution

ALL VARIABLES ARE I(1)

DOFIN, Bucharest, June 2002

long run equilibrium on the labour market johansen cointegration test
LONG RUN EQUILIBRIUM ON THE LABOUR MARKETJohansen cointegration test

REMARK: SEASONAL CENTERED DUMMIES WERE INCLUDED

DUMMYDEC and DUMMYJAN; 10 LAGS IN VAR

DOFIN, Bucharest, June 2002

long run equilibrium on the labour market johansen cointegration test1
LONG RUN EQUILIBRIUM ON THE LABOUR MARKETJohansen cointegration test

DOFIN, Bucharest, June 2002

long run equilibrium on the labour market additional statistics
LONG RUN EQUILIBRIUM ON THE LABOUR MARKETAdditional statistics

DOFIN, Bucharest, June 2002

long run equilibrium on the labour market additional statistics1
LONG RUN EQUILIBRIUM ON THE LABOUR MARKETAdditional statistics

DOFIN, Bucharest, June 2002

long run equilibrium on the labour market error correction term 8 8
LONG RUN EQUILIBRIUM ON THE LABOUR MARKETError correction term (8/8)

MODELLING APPROACH

DOFIN, Bucharest, June 2002

relative price adjustments 1 7 theoretical considerations
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

assymetric shocks are very important

Ball and Mankiw (1994) explain the mechanism

through which inflation is influenced by the variance of the shocks

trend inflation is very important

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 qualityimprovements

- the Balassa-Samuelsoneffects

DOFIN, Bucharest, June 2002

relative price adjustments 2 7
RELATIVE PRICE ADJUSTMENTS (2/7)

35 classes of goods and services in the CPI structure

DOFIN, Bucharest, June 2002

relative price adjustments 3 7
RELATIVE PRICE ADJUSTMENTS (3/7)

DOFIN, Bucharest, June 2002

relative price adjustments 4 7
RELATIVE PRICE ADJUSTMENTS (4/7)

Highest price changes between 1997 and 2002

Smallest price changes between 1997 and 2002

DOFIN, Bucharest, June 2002

relative price adjustments 5 7
RELATIVE PRICE ADJUSTMENTS (5/7)

DOFIN, Bucharest, June 2002

relative price adjustments 7 7
RELATIVE PRICE ADJUSTMENTS (7/7)

MODELLING APROACH

DOFIN, Bucharest, June 2002

administrated prices
ADMINISTRATED PRICES

Twelve month percentage change

DOFIN, Bucharest, June 2002

slide33

ADMINISTRATED PRICES “Net inflation” (3)

Autonomous inflation:27,99 % per annum

Inflation inertia:0.19

DOFIN, Bucharest, June 2002

administrated prices net inflation 4
ADMINISTRATED PRICES “Net inflation” (4)

MODELLING APPROACH

DOFIN, Bucharest, June 2002

short run dynamics of inflation 1 7
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

DOFIN, Bucharest, June 2002

short run dynamics of inflation 2 7
SHORT RUN DYNAMICS OF INFLATION (2/7)

DOFIN, Bucharest, June 2002

short run dynamics of inflation 3 7
SHORT RUN DYNAMICS OF INFLATION (3/7)

DOFIN, Bucharest, June 2002

short run dynamics of inflation 4 7 impulse response function
SHORT RUN DYNAMICS OF INFLATION (4/7)Impulse response function

DOFIN, Bucharest, June 2002

conclusion and policy implications 1 2
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

DOFIN, Bucharest, June 2002

conclusion and policy implications 2 2
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

DOFIN, Bucharest, June 2002

the facts1
The facts ...

DOFIN, Bucharest, June 2002