determinants of inflation in romania

Determinants of inflation

in Romania

ACADEMY OF ECONOMIC STUDIES BUCHARESTDOCTORAL SCHOOL OF FINANCE AND BANKING

Supervisor:Prof. MOISĂ ALTĂR

Student: FIROIU IULIA

BUCHAREST- July 2007-

Introduction

• 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:

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.

1. I identified a long-run equation in the monetary and labor sectors;

2. I estimated the inflation equation by incorporating the error correction terms derived from each co integration relationship into the short run model (ECM Model).

Money market

M2(Y, Dr, RER)

Goods market

ΔP (ULCt-Pt, RER)

VAR model

Inflation (ΔP)

Real money (M2R)

Real Exchange Rate (RER)

Labor shares (St=ULCt-Pt)

deviations from the long-run equilibrium

Monthly data:

The Balassa-Samuelson Effect:

The productivity grows faster in

the tradable sector

The wage increases in both sectors

The prices of non-tradable goods rise

The overall price level in the economy increases

I analyzed the impact of the difference in productivity between tradable and non-tradable sectors on inflation.

Most of Central Europe’s transition economies have experienced a very rapid productivity growth, especially in the industrial sector.

Quarterly data:

Melisso Boschi and Alessandro Girardi (2005) - determinants of inflation in the Euro Area economy – find a stable long-run relation connecting the price index, labor shares and import prices.

MONEY DEMAND:

LITERATURE REVIEW

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:

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.

Balassa-Samuelson Effect:

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.

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.

Johansen Cointegration Test for the money demand function:

No deterministic trend (restricted constant) – 4 lags in the VAR

Eigenvalue Trace Statistic

5%

Critical Value

1%

Critical Value

None ** 0.460440 107.1216 53.12 60.16

At most 1 ** 0.337411 58.37854 34.91 41.07

At most 2 ** 0.175036 25.86216 19.96 24.60

At most 3 * 0.126243 10.66132 9.24 12.97

*(**) denotes rejection of the hypothesis at the 5%(1%) level

Trace test indicates 3 cointegrating equation(s) at the 1% level

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).

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)

-.4

-.2

.0

.2

.4 10.8

11.2

11.6

12.0

12.4

12.8

2000 2001 2002 2003 2004 2005 2006

Residual Actual Fitted

Actual vs fitted M2

The monetary policy has been rather passive and subordinate to other policy objectives (the exchange rate policy).

Variable Coef. Std. Error t-Statistic Prob.

c 0.036557 0.003279 11.14961 0.0000

DEPR -0.001249 0.001134 -1.101944 0.2739

DLYSA -0.840221 0.239528 -3.507811 0.0008

DEXCHRATE -0.016490 0.041299 -0.399267 0.6908

EMM(-1) -0.007218 0.004355 -1.657527 0.1014

R-squared 0.510414 Mean dependent var

0.014026

Adjusted R-squared

0.485307 S.D. dependent var

0.013691

S.E. of regression

0.009822 Akaike info criterion

-6.350024

Sum squared resid

0.007525 Schwarz criterion

-6.204310

Log likelihood 268.5260 F-statistic 20.32960

Durbin-Watson stat

1.525251 Prob(F-statistic)

0.000000

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

Variable Coefficient Std. Error t-Statistic Prob.

C 0.034874 0.002525 13.80948 0.0000

DEPR -0.001425 0.001115 -1.278146 0.2050

DLYSA -0.703238 0.246116 -2.857338 0.0055

DEXCHRATE

-0.015608 0.040711 -0.383393 0.7025

EMMRES(-1)

-0.010571 0.004709 -2.244880 0.0276

R-squared 0.523928 Mean depend.Var

0.014026

Adjusted R-squared

0.499514 S.D. dependent

var

0.013691

S.E. of regression

0.009686 Akaike info criterion

-6.378014

Sum squared resid

0.007317 Schwarz criterion

-6.232301

Log likelihood

269.6876 F-statistic 21.46020

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 monththe agents will reduce their money holdings.

Stability Tests for the money demand Error-Correction Equation

-30

-20

-10

0

10

20

30

2001 2002 2003 2004 2005 2006

CUSUM 5% Significance

Both specifications are stable in terms of the parameters.

-.02

-.01

.00

.01

.02

.03

.04

.05

.06

2001 2002 2003 2004 2005 2006

Recursive C(1) Estimates ± 2 S.E.

-2.0

-1.6

-1.2

-0.8

-0.4

0.0

0.4

2001 2002 2003 2004 2005 2006


-.15

-.10

-.05

.00

.05

.10

.15

.20

2001 2002 2003 2004 2005 2006


-.004

-.003

-.002

-.001

.000

.001

.002

.003

2001 2002 2003 2004 2005 2006


-.03

-.02

-.01

.00

.01

2001 2002 2003 2004 2005 2006


Pairwise Granger Causality Tests Null Hypothesis: 1 lag

Prob2

lagsProb

3 lagsProb

4 lagsProb

5 lagsProb

6 lagsProb

12 lags Prob

LYSA does not Granger Cause REALMON_SA

1.9E-09

5.9E-05

0.00163

0.00578

0.06937

0.17505

0.31068

EXCHRATE does not Granger Cause REALMON_SA

0.12267

0.37732

0.68928

0.73686

0.76687

0.75280

0.98586

DEPR does not Granger Cause REALMON_SA

0.00083

0.09904

0.02266

0.05907

0.02882

0.08473

0.00935

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.

2. The markup model

zt=pt – γ * ulct – δ * pmt – η * πt = qt – η * πt (1) zt= γ*(pt-ulct)+ δ*(pt-pmt)- η*πt (2) β1*(ulct-pt)+β2*( pmt-pt) + et = πt (3)

where zt = retail markup over costs at time t,

qt is the “gross markup” , πt= Δpt = inflation rate;

γ>=0 and δ>=0 = elasticities of the price level with respect to unit labor costs and import costs;

(satisfy the homogeneity restriction γ+ δ=1);

η = inflation cost; β1= -γ/η, β2= -δ /η, and et= -zt/η

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

Monthly data:CPI = Consumer Price Index (December 1999=100); p = Log (CPI); inflation = p-p(-1)

Johansen Co integration Test for the markup model

No deterministic trend (restricted constant) – 5 lags in the VAR

Eigenvalue Trace statistic

5% Critical Value

1 % Critical Value

None ** 0.352548 69.86704 34.91 41.07

At most 1 **

0.330768 36.39436 19.96 24.60

At most 2

0.068566 5.469308 9.24 12.97


Trace test indicates 2 cointegrating equation(s) at both 5% and 1% levels

inflation=0.036927*st+0.002914*exchrate+0.211697

inflation~ I(1);st ~ I(1);exchrate~I(1).

The equilibrium error term: elab=inflatie-0.036927*st-0.002914*exchrate-0.211697

0

4

8

12

16

20

-0.02 -0.01 0.00 0.01

Series: ELABSample 2000:02 2006:12Observations 83

Mean -0.003539Median -0.003722Maximum 0.011756Minimum -0.024388Std. Dev. 0.006734Skewness -0.506726Kurtosis 3.857334

Jarque-Bera 6.093952Probability 0.047502

-.03

-.02

-.01

.00

.01

.02

2000 2001 2002 2003 2004 2005 2006

ELAB

Normality and stationarity tests for the residual from the markup model

Error Correction Equation for inflation:

Variable Coef. Std. Error t-Statistic Prob.

C 0.002140 0.002776 0.770865 0.4433

DINFLATIE(-1) -0.161178 0.151545 -1.063562 0.2911

DINFLATIE(-2) -0.115941 0.110307 -1.051076 0.2967

DEXCHRATE -0.042374 0.026654 -1.589775 0.1163

DST -0.001795 0.014535 -0.123514 0.9020

DREALMONSA -0.020505 0.062102 -0.330173 0.7422

ELAB(-1) -0.802889 0.190802 -4.207977 0.0001

EMMRES(-1) -0.005609 0.002447 -2.291927 0.0248

R-squared 0.559645 Mean depen. var

-0.000492

Adjusted R-squared

0.516833 S.D. dependent var

0.007882

S.E. of regression 0.005479 Akaike info criterion

-7.481181

Sum squared resid 0.002161 Schwarz criterion

-7.242978

Log likelihood 307.2472 F-statistic 13.07206

Durbin-Watson 1.617832 Prob(F-stat) 0.000000

• 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.

-.015

-.010

-.005

.000

.005

.010

.015

2001 2002 2003 2004 2005 2006

Recursive Residuals ± 2 S.E.

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.

Impulse Response (GIR) functions

-.004

-.002

.000

.002

.004

.006

.008

1 2 3 4 5 6 7 8 9 10

Response of INFLATION to INFLATION

-.004

-.002

.000

.002

.004

.006

.008

1 2 3 4 5 6 7 8 9 10

Response of INFLATION to REALMON

-.004

-.002

.000

.002

.004

.006

.008

1 2 3 4 5 6 7 8 9 10

Response of INFLATION to EXCHRATE

-.004

-.002

.000

.002

.004

.006

.008

1 2 3 4 5 6 7 8 9 10

Response of INFLATION to ST

-.02

-.01

.00

.01

.02

.03

.04

1 2 3 4 5 6 7 8 9 10

Response of REALMON to INFLATION

-.02

-.01

.00

.01

.02

.03

.04

1 2 3 4 5 6 7 8 9 10

Response of REALMON to REALMON

-.02

-.01

.00

.01

.02

.03

.04

1 2 3 4 5 6 7 8 9 10

Response of REALMON to EXCHRATE

-.02

-.01

.00

.01

.02

.03

.04

1 2 3 4 5 6 7 8 9 10

Response of REALMON to ST

-.03

-.02

-.01

.00

.01

.02

.03

1 2 3 4 5 6 7 8 9 10

Response of EXCHRATE to INFLATION

-.03

-.02

-.01

.00

.01

.02

.03

1 2 3 4 5 6 7 8 9 10

Response of EXCHRATE to REALMON

-.03

-.02

-.01

.00

.01

.02

.03

1 2 3 4 5 6 7 8 9 10

Response of EXCHRATE to EXCHRATE

-.03

-.02

-.01

.00

.01

.02

.03

1 2 3 4 5 6 7 8 9 10

Response of EXCHRATE to ST

-.03

-.02

-.01

.00

.01

.02

.03

.04

1 2 3 4 5 6 7 8 9 10

Response of ST to INFLATION

-.03

-.02

-.01

.00

.01

.02

.03

.04

1 2 3 4 5 6 7 8 9 10

Response of ST to REALMON

-.03

-.02

-.01

.00

.01

.02

.03

.04

1 2 3 4 5 6 7 8 9 10

Response of ST to EXCHRATE

-.03

-.02

-.01

.00

.01

.02

.03

.04

1 2 3 4 5 6 7 8 9 10

Response of ST to ST

Response to Generalized One S.D. Innovations ± 2 S.E.

• 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.

Period S.E. INFLATION REALMON EXCHRATE ST

1 0.005285 100.0000 0.000000 0.000000 0.000000

2 0.005645 87.86440 7.145527 4.819774 0.170294

3 0.005658 87.46893 7.116406 4.920808 0.493855

4 0.005701 86.84927 7.093243 4.905791 1.151699

5 0.005770 85.28335 7.902958 4.793715 2.019977

6 0.005820 83.84248 9.066248 5.059694 2.031573

7 0.005831 83.63422 9.035602 5.144102 2.186080

8 0.005849 83.12401 9.277654 5.113768 2.484568

9 0.005864 82.82599 9.409582 5.127039 2.637392

10 0.005870 82.72798 9.393263 5.127278 2.751483

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.

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)1. 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.

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)

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

VAR Lag Order Selection Criteria

Endogenous variables ptrad ulct

Lag LogL LR FPE AIC SC HQ

0 33.9431

2

NA 0.000294

-2.457163

-2.360386

-2.429295

1 83.7243

3

88.074

45*

8.70E-06*

-5.978795*

-5.688465*

-5.895190

*

2 85.9889

1

3.6581

74

1.00E

-05

-5.845301

-5.361418

-5.705960

* indicates lag order selected by the criterion-1.5

-1.0

-0.5

0.0

0.5

1.0

1.5

-1.5 -1.0 -0.5 0.0 0.5 1.0 1.5

Inverse Roots of AR Characteristic Polynomial

inflation ~I(1);ptrad ~ I(1);ulct ~ I(1);difprod ~ I(1).

Stability VAR (1)

Johansen Cointegration Test - the relationship between prices and unit labour costs in the tradable

sector

No deterministic trend (restricted constant) – 1 Lag

Eigenvalue TraceStatistic

5 %Critical Value

1 %Critical Value

None ** 0.528436 34.72969 19.96 24.60

At most 1 **

0.442369 15.18550 9.24 12.97


Trace test indicates 2 cointegrating equation(s) at both 5% and 1% levels

ptrad=1.026758*ulct+6.017215

=> the difference between net nominal wages and productivity in industry translates fully into the tradable prices.

Endogenous variables: INFLATIE DIFPROD

Lag LogL LR FPE AIC SC HQ

0 74.83339 NA 3.33E-06

-6.93651 -6.83703 -6.91492

1 87.67558 22.015 1.44E-06

-7.77862 -7.48019 -7.71385

2 97.61135 15.140 8.31E-07

-8.34393 -7.84654 -8.23599

3 104.6049 9.3247 6.46E-07

-8.62903 -7.93268 -8.47791

4 115.3903 12.326* 3.62E-07*

-9.27527 -8.379* -9.08096

5 120.3628 4.7356 3.69E-07

-9.367* -8.27362 -9.130*

* indicates lag order selected by the criterion

VAR Lag Order Selection Criteria

-1.5

-1.0

-0.5

0.0

0.5

1.0

1.5

-1.5 -1.0 -0.5 0.0 0.5 1.0 1.5

Inverse Roots of AR Characteristic Polynomial

Stability VAR (4)

Johansen Cointegration Test - the relationship between the productivity differential and inflation

Trend assumption: No deterministic trend (restricted constant) – 4 lags in the VAR

Hypothesized

No. of CE(s)

Eigenvalue

TraceStatistic

5 %Critical Value

1 %Critical Value

None ** 0.498675 25.20869 19.96 24.60

At most 1 * 0.365774 10.01768 9.24 12.97




inflation=0.15*difprod-0.002341.

-.04

-.02

.00

.02

.04

.06

.08

.10

2000 2001 2002 2003 2004 2005 2006

RES02

The stationarity test for the residual

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.

• 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.

Conclusions:

determinants of inflation in romania

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