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Determinants of inflation in Romania

ACADEMY OF ECONOMIC STUDIES BUCHAREST DOCTORAL SCHOOL OF FINANCE AND BANKING. Determinants of inflation in Romania. Student: FIROIU IULIA. Supervisor : Prof. MOISĂ ALTĂR. BUCHAREST

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Determinants of inflation in Romania

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  1. ACADEMY OF ECONOMIC STUDIES BUCHAREST DOCTORAL SCHOOL OF FINANCE AND BANKING Determinants of inflation in Romania Student: FIROIU IULIA Supervisor: Prof. MOISĂ ALTĂR BUCHAREST - July 2007-

  2. Introduction The objective of the paper is to provide some answers to the question: how has inflation been reduced in Romania and what policies proved to be effective in stabilizing economy. • Monetary inflation - when the supply of money is greater than the level of output (pure monetary theory – Friedman (1969)) • Wage inflation - wages increases more than labor productivity, raising the unit labor costs • The transmission of import prices in a foreign currency leads to general domestic inflation. I assumed there are three sources of inflation:

  3. Monthly data: deviations from the long-run equilibrium I identified a long-run equation in the monetary and labor sectors; I estimated the inflation equation by incorporating the error correction terms derived from each co integration relationship into the short run model (ECM Model).

  4. Most of Central Europe’s transition economies have experienced a very rapid productivity growth, especially in the industrial sector. I analyzed the impact of the difference in productivity between tradable and non-tradable sectors on inflation. Quarterly data: The Balassa-Samuelson Effect: The productivity grows faster in the tradable sector

  5. LITERATURE REVIEW Melisso Boschi and Alessandro Girardi (2005) - determinants of inflation in the Euro Area economy –find astable long-run relation connecting the price index, labor shares and import prices. Brada and Kutan (1999) - three transition countries (Czech Republic, Hungary and Poland), -inflation is determined largely by past inflation and by foreign prices; - monetary policy is relatively ineffective Markup Model: MONEY DEMAND: Balassa-Samuelson Effect: De Grauwe and Skudelny (2000) test the Balassa-Samuelson effect for 13 of the 15 EU member countries ( period 1971-1995); - differences in productivity growth between sectors translates into a change in CPI with a coefficient of 0.3.

  6. 1. LONG RUN EQUILIBRIUM ON THE MONEY MARKET Md = f(Y ; r; x) Md = money demand in real terms; Y = the level of economic activity, r = the opportunity cost of holding money, and x is a vector of other variables which will be included in the model. Monthly data:realmon_sa = Log (RON M2 / CPI) seasonally adjusted (with Tramo/Seats)ppi_sa = Industrial production index (December 1999=100) seasonally adjusted (with Tramo/Seats) (%)lysa = Log (ppi_sa); seasonally adjusted (with Tramo/Seats)depr = Nominal deposit rate applied by banks to non-governamental non-bank customers (%)e= Nominal exchange rate RON/EURexch= Log (e)p = Log (HICP Romania_dec97);pf = Log (HICP Eur13_dec97)exchrate ( pf + exch-p) =Real exchage rate RON/ EUR based on HICP.

  7. Johansen Cointegration Test for the money demand function: realmon_sa = 7.290638+0.651103 * lysa-0.049206 * depr -1.478535 * exchrate The residual: Emm = realmon_sa-7.29 -0.65 * lysa +0.049*depr+ 1.47 * exchrate ~I(0) realmon_sa~I(1) lysa ~ I(1); depr ~ I(1); exchrate~I(1).

  8. I tested in VEC - the restriction B(1,1)=1 and B(1,2)=-1 (3 lags in VAR). realmon_sa = 5.620331+lysa-0.034615*depr-1.297562*exchrate The residual: Emmres = realmon_sa - 5.620331- lysa +0.034615*depr+1.297562*exchrate ~ I(0) Actual vs fitted M2 The monetary policy has been rather passive and subordinate to other policy objectives (the exchange rate policy).

  9. Error Correction Equation for the real M2 from the unrestricted VAR:

  10. Error Correction Equation for the real M2 from the restricted VAR If there is an excess of money in the present month, in the next month the agents will reduce their money holdings.

  11. Stability Tests for the money demand Error-Correction Equation Both specifications are stable in terms of the parameters.

  12. Pairwise Granger Causality Tests • RESULTS: • Between the real money M2 (realmoney_sa) and the industrial production (lysa) there is a short term causality relationship. • The real exchange rate (exchrate) doesn’t seem to influence the real money M2. • There is also a long term relationship between M2 and the deposit rate.

  13. 2. The markup model Monthly data: CPI = Consumer Price Index (December 1999=100); p = Log (CPI); inflation = p-p(-1) Iprod = Labour productivity index in industry (December 1999 =100); ratio between index of industrial production and index of number of employees; prod = Log (Iprod); st=ulct-p =Labor share = wage-prod-p = realwage - prod

  14. Johansen Co integration Test for the markup model inflation~ I(1); st ~ I(1); exchrate~I(1). inflation=0.036927*st+0.002914*exchrate+0.211697

  15. The equilibrium error term:elab=inflatie-0.036927*st-0.002914*exchrate-0.211697 Normality and stationarity tests for the residual from the markup model

  16. Error Correction Equation for inflation:

  17. If wages affect prices, their effect is realized mainly through the magnitude of disequilibrium in the labor sector rather than its unit impact on prices. The speed of adjustment towards the equilibrium is very high (80.28% is absorbed in the next period). This suggests that when the economy is shocked away from the long-run relationship, adjustment back to equilibrium is realized by changes in the rate of inflation through actions of the monetary authorities. • The coefficient of the error correction term from the money demand relationship is small indicating that there is little effect of excess money on inflation. This is in line with a finding by Brada and Kutan (1999), who suggested that monetary policy in Poland has been used mainly to support the exchange rate policy.

  18. Recursive Residuals Tests for the Error-Correction equation for inflation This figure shows that there is little evidence of regime shifts: variations in the inflation variable are within +/-5% innovation errors.

  19. Impulse Response (GIR) functions • A shock in the inflation equation implies only a temporary effect on the next evolution of inflation. • It takes only two months for the shock to real money to exert a maximum influence on prices, that is 1% • The response of prices to real wage shocks shows a cyclical pattern over the first six months, after that the shock is absorbed. • The impact response of prices, given a shock to exchange rate, is 1% in the second month and after three months the shock dies out.

  20. Variance Decomposition of Inflation Real money seems to be the main factor of influence for inflation; the second place is taken by the real exchange rate. The labor share (ulct-pt) has little consequences on variations of inflation.

  21. 3. The Balassa – Samuelson Model • It is assumed that economies are characterized by two different production functions with constant returns to scale, one for the production of tradable (mainly industrial goods), and one for non-tradable (mainly services). • b (1-b) • Yt = At * (Lt) + (Kt) • c (1-c) • 2. Ynt = Ant * (Lnt) + (Kt) , • where Y = output, A = total factor productivity, L = labour, K = capital, t / nt =tradable / non-tradable good sectors, b and c = labor intensity in the two sectors. First, I will test the relation between unit labor costs and prices in industry: ln Ptrad = ln b + β * ln ULCt + εt, where β is expected to be positive and equal to 1.

  22. Secondly, I will test the Balassa - Samuelson hypothesis: the total price level should be driven by the productivity differential between the tradable and non tradable goods sectors Quarterly data: CPI = Consumer Price Index (2000:Q1=100) ; p = Log(CPI); inflation = p-p(-1) ; CPItrad =Consumer Price Index in the tradable sector (2000:Q1=100); ptrad = Log(CPItrad); I_prod_trad = Labour productivity index in the tradable sector (2000:Q1=100) = ratio GDP and the number of employees in the tradable sector; prodtrad = Log(I_prod_trad); I_prod_nontrad = Labour productivity index in the tradable sector (2000:Q1=100); ratio between GDP and the number of employees in the nontradable sector; prodnontrad = Log(I_prod_nontrad); difprod = prodtrad-prodnontrad; Iulct = Unit labor cost index in the tradable sector (ratio between index of real nominl net wage in industry and index of industrial production); ulct = Log (Iulct)

  23. VAR Lag Order Selection Criteria inflation ~I(1); ptrad ~ I(1); ulct ~ I(1); difprod ~ I(1). Stability VAR (1)

  24. Johansen Cointegration Test - the relationship between prices and unit labour costs in the tradable sector ptrad=1.026758*ulct+6.017215 => the difference between net nominal wages and productivity in industry translates fully into the tradable prices.

  25. VAR Lag Order Selection Criteria Stability VAR (4)

  26. Johansen Cointegration Test - the relationship between the productivity differential and inflation The stationarity test for the residual inflation=0.15*difprod-0.002341.

  27. Conclusions: • There is a long-run stable relationship between M2 and the other three variables: the index of industrial production the deposit interest rate and the real exchange rate • I found that there is little effect of excess money on inflation. In Romania, the same as in other transition economies, the monetary policy was mainly subordinated to the exchange rate policy. • Co integration techniques and error correction models used to estimate the relationship between markup and inflation dynamics show a relation between prices and marginal costs and that inflation error-corrects towards this equilibrium.

  28. Conclusions: • According to the Johansen test the production costs influence inflation. That’s why, in order to assure the stability of prices, the fiscal authorities should play an important role in the inflation process. • the Error-correction Model (ECM) for inflation revealed that, on the short-term basis, the policy of wages affects inflation in an indirect way through the magnitude of disequilibrium in the labor sector rather than its unit impact on prices. • The Co integration Tests of the Balassa - Samuelson hypothesis show that in the industry sector the unit labor costs fully translates into the level of prices and that the productivity growth differential between sectors has a positive effect on inflation.

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