ACADEMY OF ECONOMIC STUDIES BUCHAREST

DOCTORAL SCHOOL OF FINANCE AND BANKING

INFLATION DYNAMICS IN ROMANIA: A NEW KEYNESIAN PHILLIPS CURVE

APPROACH

Student: Razvan Radu

Supervisor: Professor Moisa Altar

BucharestJuly 2006

Contents

• Objectives

• Literature review

• The Model

• Empirical Specification

• The Data

• Results

• Conclusions

Objectives

• To analyse the short-run inflation dynamics in Romania

• To identify the structural parameters that characterize the firms’ princing behavior

• To assess the extent to which forward and backward looking price setting characterize the inflationary process

• To compare the nature of Romanian inflation with that reported for other economies

The New Keynesian Phillips Curve

• Based on the seminal work by Taylor (1980), Calvo (1983)

• The NKPC is derived explicitly from an optimization process, assuming staggered price setting by forward looking, monopolistically competing firms

• Current inflation is related to future expected inflation and real marginal cost

• The parameters of the NKPC are directly linked to the behavior of agents and are thus exempt from the Lucas critique

The New Keynesian Phillips Curve• Gali and Gertler (1999) extend the NKPC,

incorporating inflation inertia• Gali and Gertler (1999) - US• Gali, Gertler and Lopez-Salido (2001) - Euro Area• Leith and Malley (2002) - G7 countries• Balakrishnan and Lopez-Salido (2002) - UK• Rumler (2005) - Euro Area countries• Ribon (2004) - Israel• Cespedes, Soto and Ochoa (2005) - Chile• Lendvai (2005) - Hungary

The Model• Gali and Gertler (1999)

• The supply side of the economy consists of a continuum of monopolistically competing firms the size of which is normalized to one

• Each period a random fraction of firms reset their price, while all others firms keep their price unchanged

• Only a fraction of firms adjust their prices optimally in a forward looking manner, the remaining firms are backward looking and set their prices based on the recent aggregate price behavior

1

1

1. Closed economy model

tttftbt mcE )( 11

b

where the coefficients of the lagged inflation, the expected inflation and the marginal cost are functions of the deep parameters:

,

f

)1)(1)(1(

)1(1

2. Open economy model

Open economy effects are incorporated by modeling imported goods as intermediate production goods

Assuming a Cobb-Douglas technology, the real marginal cost has the form:

tttt mawmc )1()( - real wage tw

tm

- labor-augmenting technologyta

- real cost of a unit of the imported good

- labor’s share in gross output

tm

ttl

tbttft mawE )(11

b

f

)1)(1)(1(

l

)1)(1)(1)(1(

m

)1(1

Empirical Specification

ttttftbt mcE )( 11

ttm

ttl

ttftbt qawE )()( 11

twhere is an inflation shock, which is an innovation with respect to information set dated or earlier. 1t

Assuming rational expectations,

111 )( tttt E

1twhere is the forecast error in predicting future inflation, and hence a innovation with respect to contemporaneous and past information

tttftbt emc 11

ttm

ttl

tftbt eqaw )(11

1 tftte

The following orthogonality conditions can be written, forming the basis for estimating the model by the Generalized Method of Moments (Hansen, 1982).

0])[( 11 tttftbtt ZmcE

0]))([( 11 ttm

ttl

tftbtt ZqawE

tZ is a vector of instrumental variables which must be uncorrelated with te

GMM in the presence of “weak instruments”

• Stock, Wright and Yogo (2002), Kleibergen (2002), Dufour and Jasiak (2001), Dufour (2003), Dufour, Khalaf and Kichian (2005)

• When instruments are weakly correlated to endogenous variables, the sampling distributions of GMM statistics are in general non-normal and standard GMM estimates, hypothesis tests and confidence intervals are unreliable

• The empirical relevance of the results will also be examined using two type of tests (AR-statistic and K-statistic) the properties of which are robust in finite samples to the quality

of instruments

The AR statistic

Anderson-Rubin (1949), Dufour (2003), Dufour, Khalaf and Kichian (2005)

ukXYy 1

)1( Ty

)( mTY tmc1t

1t - vector of observations on dependent variable ( )t

- matrix of endogenous variables ( , )

)(11kT

X

- matrix of exogenous variables ( )

u - error term, which is an innovation with respect to exogenous variables

VXXY 2211

Assume that the reduced form for the endogenous variables is:

where is a matrix of error terms assumed to be

cross-correlated and correlated with and is the

matrix of instruments

)( mTV u

)(22kT

X

VupXpXy 2211

kp 11

22 p

Identification requires that the matrix have full rank 2

ukkXYkXYy )()( 01

01

00

00 ,: kkH o

)()]([)]()([ 00220

01101

0 VuXkkXkXYy

Given that the AR-test has low power when the number of instruments strongly exceeds the number of parameters to be estimated, Kleibergen (2002) propose to project the disturbances of the structural equation on the instrument set given by

22XZ

where is the coefficient of in the regression of on and .

2

2X

Y 1X2X

The AR-statistic assesses the exclusion of and in the regression of on and .

1X 2X

010 kXYy

1X 2X

The DataQuarterly data are used, covering the period 1998Q1:2005Q4. All series are in logarithms.

gdp_r Real GDP, in 2003 constant prices

cpi Consumer price index, 1990=100, quarterly average

coreCore price index, computed from CPI by exclusion of administered prices

l_infl_cpi Annualized quarter on quarter CPI inflation ratel_infl_core Annualized quarter on quarter core inflation rateppi Producer prices index, 2000=100, quarterly average

ind_prodIndustrial production index, 1993=100, quarterly average

wageGross average wage in industrial sector index, 2000=100, quarterly average

emplEmployment in industrial sector index, 1993=100, quarterly average

l_ulcReal unit labor cost in industrial sector, computed as a ratio between the real average gross wage index and productivity index

infl_cpi CPI inflation* infl_core Core inflation* ulc Unit labor cost* gap Output* rer Real exchange rate*

* Detrended using HP filterThe series are seasonally adjusted using X-12 procedure

.0

.1

.2

.3

.4

.5

.6

.7

.8

98 99 00 01 02 03 04 05

L_INFL_CORE

CORE INFLATION

.0

.1

.2

.3

.4

.5

.6

.7

.8

98 99 00 01 02 03 04 05

L_INFL_CPI

CPI INFLATION

-.3

-.2

-.1

.0

.1

.2

.3

.4

98 99 00 01 02 03 04 05

INFL_CORE

CORE INFLATION

Actual and detrended data

-.3

-.2

-.1

.0

.1

.2

.3

.4

98 99 00 01 02 03 04 05

INFL_CPI

CPI INFLATION

-.12

-.08

-.04

.00

.04

.08

.12

98 99 00 01 02 03 04 05

ULC

REAL ULC

-.03

-.02

-.01

.00

.01

.02

.03

.04

.05

.06

98 99 00 01 02 03 04 05

GAP

OUTPUT GAP

-4.9

-4.8

-4.7

-4.6

-4.5

-4.4

-4.3

98 99 00 01 02 03 04 05

L_ULC

REAL ULC

10.60

10.65

10.70

10.75

10.80

10.85

10.90

10.95

98 99 00 01 02 03 04 05

L_GDP_R

REAL GDP

2.7

2.8

2.9

3.0

3.1

3.2

98 99 00 01 02 03 04 05

L_RER

REAL EXCHANGE RATE

-.12

-.08

-.04

.00

.04

.08

.12

.16

98 99 00 01 02 03 04 05

RER

REAL EXCHANGE RATE

-.4

-.3

-.2

-.1

.0

.1

.2

.3

.4

.5

-.03

-.02

-.01

.00

.01

.02

.03

.04

.05

.06

1998 1999 2000 2001 2002 2003 2004 2005

INFL_CORE OUTPUT GAP

CORE INFLATION AND OUTPUT GAP

-.3

-.2

-.1

.0

.1

.2

.3

.4

-.12

-.08

-.04

.00

.04

.08

.12

.16

1998 1999 2000 2001 2002 2003 2004 2005

INFL_CORE ULC

CORE INFLATION AND ULC

In the theoretical model, the actual inflation rate is modeled as a deviation from a zero steady state. This assumption seems not appropiate in the case of the Romanian economy, as the inflation rate evolved along a downward convergence path.

Consequently, I choose to model the fluctuations of inflation around its trend, following Coenen and Wieland (2000, 2004), Coenen and Levin (2004), Ribon (2004), Rumler (2005).

Results

f b J test

(p-value)

AR test

(p-value)

K test

(p-value)

0.491

(0.110)

0.442

(0.071)

0.161

(0.035)0.777 0.696 0.145

0.506

(0.043)

0.494

(0.043)

0.062

(0.025)0.812 0.603 0.078

1.1. Closed economy model

1. Reduced-form estimates

The instruments set includes three lags of: the core inflation, the deviation of unit labor cost from the trend and the output gap (from t-2 to t-4); and the lagged deviation of real exchange rate from the trend (t-2).

f b l mJ test

(p-value)

AR test

(p-value)

K test

(p-value)

0.571

(0.042)

0.261

(0.035)

0.428

(0.039)

0.726

(0.063)

0.847 0.211 0.516

0.729

(0.017)

0.271

(0.017)

1.359

(0.124)

0.336

(0.017)

0.759 0.129 0.194

1.2 Open economy model

The instruments set consists of three lags of: the core inflation, the output gap, the deviation of the real exchange rate from its trend and

the change in real exchange rate (from t-2 to t-4 ).

f b DJ test

(p-value)

AR test

(p-value)

K test

(p-value)

0.546

(0.050)

0.396

(0.062)

0.799

(0.158)

0.485

(0.114)

0.441

(0.074)

0.172

(0.045)

2.201

(0.244)0.779 0.701 0.150

0.552

(0.052)

0.404

(0.060)

0.812

(0.154)

0.491

(0.110)

0.442

(0.071)

0.161

(0.045)

2.232

(0.258)0.777 0.697 0.145

0.567

(0.071)

0.575

(0.042)0.99

0.493

(0.043)

0.504

(0.043)

0.070

(0.037)

2.312

(0.380)0.806 0.593 0.067

0.587

(0.075)

0.566

(0.042)0.99

0.506

(0.043)

0.492

(0.043)

0.065

(0.038)

2.421

(0.440)0.814 0.607 0.074

Instrumental variables include three lags of: the core inflation, the deviation of unit labor cost from the trend and the output gap (from t-2 to t-4 ); and the lagged deviation of real exchange rate from the trend (t-2).

2. Structural-form estimates

2.1 Closed economy model

US, Euro Area 0.80-0.90 Gali, Gertler, Lopez-Salido (2001)Spain 0.85-0.90 Gali, Lopez-Salido (2001)Hungary 0.50-0.65 Lendvai (2005)Israel 0.50-0.60 Ribon (2004)

Estimates for other economies

Euro Area 0.02-0.30 Gali, Gertler, Lopez-Salido (2001)US 0.40-0.45 Gali, Gertler, Lopez-Salido (2001)Spain 0.70 Gali, Lopez-Salido (2001)Hungary 0.30-0.55 Lendvai (2005)Israel 0.40-0.50 Ribon (2004)

Price stickiness ( )

Fraction of backward looking price setters ( )

2.1 Open economy model

f b l m DJ test

(p-value)

AR test

(p-value)

K test

(p-value)

0.389

(0.043)

0.116

(0.080)

0.733

(0.071)

0.859

(0.056)

0.578

(0.014)

0.235

(0.014)

0.675

(0.009)

0.109

(0.002)

1.636

(0.114)

0.954 0.670 0.396

0.403

(0.045)

0.171

(0.097)

0.675

(0.095)

0.879

(0.087)

0.493

(0.017)

0.310

(0.017)

0.573

(0.002)

0.078

(0.004)

1.676

(0.127)

0.947 0.560 0.293

The set of instrumental variables consists of three lags of: the core inflation, the deviation of unit labor cost from the trend, the deviation of real exchange rate from its trend and the change of the real exchange rate (from t-2 to t-4 ); the lagged output

gap (t-2).

f b l m DJ test

(p-value)

AR test

(p-value)

K test

(p-value)

0.249

(0.075)

0.157

(0.053)

0.990.761

(0.047)

0.607

(0.120)

0.387

(0.121)

0.895

(0.389)

0.274

(0.142)

1.331

(0.133)

0.8400.863 0.120

0.237

(0.016)

0.265

(0.021)

0.990.815

(0.012)

0.467

(0.037)

0.529

(0.037)

0.700

(0.019)

0.158

(0.012)

1.309

(0.028)

0.7840.743 0.054

Instruments include three lags of: the detrended core inflation, the deviation of the unit labor cost from its trend, the deviation of real exchange rate from the trend and

the output gap (from t-2 to t-4 ).

Price stickiness ( )Euro Area 0.68 Rumler (2005)US 0.55 Leith and Malley (2002)UK 0.60 Leith and Malley (2002)Canada 0.70 Leith and Malley (2002)France 0.70 Leith and Malley (2002)Japan 0.70 Leith and Malley (2002)Germany 0.80 Rumler (2005), Leith and Malley (2002)Italy 0.70 Rumler (2005)Hungary 0.50-0.70 Lendvai (2005)Israel 0.50-0.60 Ribon (2004)

Fraction of backward looking price setters ( )

Euro Area 0.50 Rumler (2005)Germany 0.21, 0.65 Leith and Malley (2002), Rumler (2005)Italy 0.43, 0.35 Leith and Malley (2002), Rumler (2005)US 0.30 Leith and Malley (2002)Canada 0.30 Leith and Malley (2002)Japan 0.30 Leith and Malley (2002)Hungary 0.30-0.50 Lendvai (2005)Israel 0.40-0.50 Ribon (2004)

Estimates for other economies

J test (p-value)

AR test (p-value)

K test (p-value)

0.300.471

(0.072)0.329

(0.122)0.584

(0.015)0.412

(0.015)0.071

(0.002)0.166

(0.004)1.890

(0.259)0.780 0.479 0.129

0.350.461

(0.072)0.321

(0.120)0.584

(0.015)0.411

(0.015)0.089

(0.002)0.166

(0.004)1.854

(0.247)0.642 0.479 0.130

0.400.450

(0.071)0.313

(0.118)0.585

(0.015)0.411

(0.015)0.110

(0.002)0.165

(0.004)1.817

(0.234)0.782 0.477 0.130

0.450.438

(0.070)0.303

(0.116)0.586

(0.014)0.410

(0.015)0.135

(0.003)0.165

(0.003)1.778

(0.222)0.782 0.476 0.130

0.500.424

(0.069)0.294

(0.114)0.586

(0.014)0.410

(0.015)0.164

(0.003)0.164

(0.003)1.737

(0.209)0.642 0.474 0.131

0.550.409

(0.069)0.284

(0.111)0.585

(0.016)0.410

(0.015)0.200

(0.004)0.164

(0.003)1.692

(0.196)0.781 0.470 0.130

0.600.391

(0.068)0.275

(0.109)0.583

(0.014)0.413

(0.015)0.244

(0.005)0.163

(0.003)1.642

(0.183)0.642 0.464 0.127

0.650.367

(0.068)0.269

(0.106)0.572

(0.014)0.424

(0.015)0.300

(0.005)0.162

(0.015)1.581

(0.170)0.770 0.448 0.117

0.700.211

(0.079)0.389

(0.084)0.348

(0.012)0.649

(0.012)0.446

(0.009)0.191

(0.004)1.267

(0.127)0.722 0.221 0.011

0.750.216

(0.074)0.366

(0.084)0.367

(0.011)0.630

(0.011)0.503

(0.009)0.167

(0.003)1.276

(0.121)0.723 0.237 0.155

0.800.243

(0.070)0.336

(0.090)0.416

(0.011)0.580

(0.011)0.526

(0.010)0.131

(0.002)1.322

(0.123)0.720 0.285 0.029

f b l m D

Influence of labor’s share on estimated parameters

Influence of labor’s share on estimated price stickiness

0

0.1

0.2

0.3

0.4

0.5

0.6

0.7

0.30 0.35 0.40 0.45 0.50 0.55 0.60 0.65 0.70 0.75 0.80

0

0.5

1

1.5

2

2.5

3

0.30 0.35 0.40 0.45 0.50 0.55 0.60 0.65 0.70 0.75 0.80

D

Actual vs. estimated values

-.1

.0

.1

.2

.3

.4

1999 2000 2001 2002 2003 2004 2005

ACTUAL FITTED

REDUCED FORM ESTIMATES - CLOSED ECONOMY

-.1

.0

.1

.2

.3

.4

1999 2000 2001 2002 2003 2004 2005

ACTUAL FITTED

STRUCTURAL ESTIMATES - CLOSED ECONOMY

-.1

.0

.1

.2

.3

.4

1999 2000 2001 2002 2003 2004 2005

ACTUAL FITTED

REDUCED FORM ESTIMATES - OPEN ECONOMY

-.1

.0

.1

.2

.3

.4

1999 2000 2001 2002 2003 2004 2005

ACTUAL FITTED

STUCTURAL ESTIMATES - OPEN ECONOMY

Conclusions• The weights of lagged and future expected inflation are roughly

equal

• The inflationary process in Romania is more inertial than in the Euro Area and other economies characterized by stable and low rates of inflation

• The inertia of inflation can be explained by the fraction of firms that set their prices in a backward-looking manner, which ranges between 0.3 and 0.4

• Firms adjust their prices approximately every 1.3 to 2.4 quarters, which imply a lower price stickiness as compared to the Euro Area

• The estimated parameters are in line with those reported in the literature for other countries that experienced periods of high inflation