determinants of inflation in romania student: covrig nicolae supervisor: prof. moisĂ altĂr

DETERMINANTS OF INFLATION IN ROMANIA

Student: COVRIG NICOLAE

Supervisor: Prof. MOISĂ ALTĂR

Determinants of Inflation in Romania

DOFIN, Bucharest, June 20022

The facts ...

0 20 40 60 80 100 120 140 160

1995

1996

1997

1998

1999

2000

2001

%

Romania Poland Hungary Czech Republic Slovakia

Inflation in CEE transition economies (annual percentage change)



The goals...

• To find out the causes of high and persistent inflation in ROMANIA

• To asses the role of monetary and other economic policies in the disinflation process



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



…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



ModellingApproach

MONEY MARKET LABOUR MARKET

FOREIGN EXCHANGE MARKET

Deviation from long-run equilibriumDeviation from long-run equilibrium(lagged one period)(lagged one period)

VAR MODEL

Short term dynamics of endogenous variables

RELATIVE PRICE ADJUSTMENTS

ADMINISTRATIVE DECISIONS ABOUT

PRICES

Exogenous variables

Cointegration analysis (in level of variables)

Sample: 1996:01 – 2002:02

Frequency: monthly



LONG RUN EQUILIBRIUM ON THE MONEY MARKETTheoretical consideration (Ericsson 1998)

),( RYfPM d

oro

iriy

d rrypm

Where:

m - nominal money demand (in log)

y - scale variable, GDP for instance (in log)

ir0y

- rate of return on money itself (expressed in level)

or - rate of return on assets outside of money (expressed in level)

0ri

0ro

0 - rate of inflation



LONG RUN EQUILIBRIUM ON THE MONEY MARKETChoice of variables for Romania case (1/8)

8.90

9.00

9.10

9.20

9.30

9.40

9.50

9.60

9.70

Jan-

96

Jan-

97

Jan-

98

Jan-

99

Jan-

00

Jan-

01

Jan-

02

9.25

9.75

10.25

10.75

11.25

11.75

12.25LM2XR (left scale)LM2XRsa (left scale)LM2X (right scale)

8.8

9.0

9.2

9.4

9.6

9.8

10.0

Jan-

96

Jan-

97

Jan-

98

Jan-

99

Jan-

00

Jan-

01

Jan-

02

LM2R LM2XR

0%

20%

40%

60%

80%

100%

Jan-96 Jan-97 Jan-98 Jan-99 Jan-00 Jan-01 Jan-02

Residents’ deposits inforeign currencies

Household savings,time, and restricteddeposits

M1R (Currency outsidebanks, and demanddeposits)

Monthly observation for M2XR where

M2XR = M2R – resident’s foreign

currency deposits

M2XR is I(1)Seasonally adjusted time series was use




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




-0.4

-0.3

-0.2

-0.1

0.0

0.1

0.2

0.3

Jan

-96

Jan

-97

Jan

-98

Jan

-99

Jan

-00

Jan

-01

Jan

-02

LY LYsa

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



LONG RUN EQUILIBRIUM ON THE MONEY MARKETJohansen cointegration analysis (4/8)

REMARK: DUMMY9703 included – cointegration test possibly affected2 LAGS IN VAR




8.5340DLEXUSD 0.0096157 -DR 0.030255 YSA 1.28732 XRSALM

LM2XRSA YSA DR DLEXUSD Intercept

Unrestricted cointegrating coefficients for:

-0.28985 0.37313 0.0087696 -0.0027871 2.4736

Normalized cointegrating coefficients for:

-1.0000 1.2873(0.42922)

[-2.99916]

0.030255(0.00430)

[-7.03754]

-.0096157(0.00219)

[ 4.38687]

8.5340(0.17448)

[-48.9117]

Adjustment coefficient for

-0.025066 0.016445 5.244893 -0.95072



LONG RUN EQUILIBRIUM ON THE MONEY MARKETStatistics for Johansen cointegration analysis (7/8)



LONG RUN EQUILIBRIUM ON THE MONEY MARKETError correction term (8/8)

-3

-2

-1

0

1

2

3

1996 1997 1998 1999 2000 2001

Error correction term for long run money demand

The large disequilibria are strongly related to the nominal exchange rate depreciations and to the nominal deposit rate increase

MODELLING APPROACH

20

30

40

50

60

70

80

90

100

1996 1997 1998 1999 2000 2001 2002

DR

-100

0

100

200

300

400

1996 1997 1998 1999 2000 2001 2002

DLEXUSD



LONG RUN EQUILIBRIUM ON THE LABOUR MARKET Theoretical consideration

LPmPW )1(Real wage W/P is a mark-up over the labour productivity LP

where )1( m and

LP

W

Y

EWP

11

P – level of price E - employment

W – net nominal wage Y - output



LONG RUN EQUILIBRIUM ON THE LABOUR MARKETVariable evolution

-.4

-.3

-.2

-.1

.0

.1

.2

.3

.4

.5

1996 1997 1998 1999 2000 2001

LWAGR LLP

-.6

-.5

-.4

-.3

-.2

-.1

.0

.1

1996 1997 1998 1999 2000 2001 2002

Real wage mark-up over labour productivity

-.1

.0

.1

.2

.3

.4

.5

.6

1996 1997 1998 1999 2000 2001 2002

Unitary price mark-up over the unitary cost with salaries

ALL VARIABLES ARE I(1)



LONG RUN EQUILIBRIUM ON THE LABOUR MARKETJohansen cointegration test

REMARK: SEASONAL CENTERED DUMMIES WERE INCLUDED

DUMMYDEC and DUMMYJAN; 10 LAGS IN VAR



LONG RUN EQUILIBRIUM ON THE LABOUR MARKETJohansen cointegration test

Variable LWAGR LLP LMARKUP Trend Intercept

Normalized adjustment coefficient for:

-0.766830.242304[-3.16475]

-0.211530.25253

[-0.83762]

0.2877760.370434[ 0.77686]

Normalized cointegrating coefficients for:

-1.0000 1.07563-0.08339

[-12.8994]

0.69167-0.05966

[-11.5943]

-0.002221-0.00025

[ 9.05362]

-0.099123

099123.0002221.069167.007563.1 TrendLMARKUPLLPLWAGR



LONG RUN EQUILIBRIUM ON THE LABOUR MARKETAdditional statistics



LONG RUN EQUILIBRIUM ON THE LABOUR MARKET Error correction term (8/8)

-.15

-.10

-.05

.00

.05

.10

.15

.20

1996 1997 1998 1999 2000 2001

Error correction model for long run real wage

MODELLING APPROACH



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

Ball and Mankiw (1994) explain the mechanism through which inflation is influenced by the variance of the shocks

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 quality improvements

- the Balassa-Samuelson effects

assymetric shocks are very important

trend inflation is very important



RELATIVE PRICE ADJUSTMENTS (2/7)35 classes of goods and services in the CPI structure



RELATIVE PRICE ADJUSTMENTS (3/7)




Highest price changes between 1997 and 2002

Smallest price changes between 1997 and 2002




0.00

0.05

0.10

0.15

0.20

0.25

0.30


-6.00

-4.00

-2.00

0.00

2.00

4.00

6.00DLCPI (divided by 100) Weighted skewness (right scale)



RELATIVE PRICE ADJUSTMENTS (6/7)High skewned distribution

0

5

10

15

20

25

30

0.0 0.2 0.4 0.6 0.8 1.0

Series: November2001Sample 1 35Observations 35

Mean 0.069435Median 0.023400Maximum 1.031220Minimum -0.078870Std. Dev. 0.173898Skewness 5.019484Kurtosis 28.35463

Jarque-Bera 1084.472Probability 0.000000




0.00

0.20

0.40

0.60

0.80

1.00

1.20

1.40


DLCPI (divided by 100)

Weighted STDV.

MODELLING APROACH



ADMINISTRATED PRICES

0

50

100

150

200

250

300

Jan-

97

Jul-9

7

Jan-

98

Jul-9

8

Jan-

99

Jul-9

9

Jan-

00

Jul-0

0

Jan-

01

Jul-0

1

Jan-

02

Fuels

Electric energy

CPI

ROL/USD

Twelve month percentage change



ADMINISTRATED PRICES“Net inflation” (1)

0

4

8

12

16

20

24

0.00 0.05 0.10 0.15 0.20 0.25

Series: DLCPISample 1996:01 2002:02Observations 74

Mean 0.037719Median 0.027615Maximum 0.267734Minimum 0.005982Std. Dev. 0.037640Skewness 3.981103Kurtosis 22.27329


0

1

2

3

4

5

6

7

8

9

0.01 0.02 0.03 0.04 0.05

Series: Net inflation 1Sample 1 62Observations 62

Mean 0.026315Median 0.024205Maximum 0.049742Minimum 0.005982Std. Dev. 0.011068Skewness 0.358194Kurtosis 2.266330


)()1,(2),()()1(21)(1

tutiimpactCtiimpactiDDLCPICCtDLCPIt

i



ADMINISTRATED PRICES “Net inflation” (2)



Autonomous inflation: 27,99 % per annum

Inflation inertia: 0.19





0.00

0.05

0.10

0.15

0.20

0.25

0.30


Headline inflation Net inflation

0

2

4

6

8

10

12

14

16

18


Net inflation Headline inflation

MODELLING APPROACH



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



SHORT RUN DYNAMICS OF INFLATION (4/7)Impulse response function

-.002

.000

.002

.004

.006

.008

.010

1 2 3 4 5 6 7 8 9 10

Response of DLCPI to DLCPI

-.002

.000

.002

.004

.006

.008

.010

1 2 3 4 5 6 7 8 9 10

Response of DLCPI to DLM2XR

-.002

.000

.002

.004

.006

.008

.010

1 2 3 4 5 6 7 8 9 10

Response of DLCPI to DLEXUSDR

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

-.008

-.004

.000

.004

.008

.012

1 2 3 4 5 6 7 8 9 10

Response of DLCPI to DLCPI

-.008

-.004

.000

.004

.008

.012

1 2 3 4 5 6 7 8 9 10

Response of DLCPI to DLM2XR

-.008

-.004

.000

.004

.008

.012

1 2 3 4 5 6 7 8 9 10

Response of DLCPI to DLEXUSDR

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



SHORT RUN DYNAMICS OF INFLATION (5/7)Variance decomposition



SHORT RUN DYNAMICS OF INFLATION (6/7)Parsimonious model



SHORT RUN DYNAMICS OF INFLATION (7/7)Parsimonious model



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



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



The facts ...

Consumer Price Index (average annual change in %)

1995 1996 1997 1998 1999 2000 20001Romania 32.3 38.8 154.8 59.1 45.9 45.7 34.1

Poland 27.8 19.9 14.9 11.8 7.3 10.1 5.5

Hungary 28.2 23.6 18.3 14.3 10 9.8 9.2

Czech Republic 9.1 8.8 8.5 10.7 2.1 3.9 4.7

Slovakia 9.9 5.8 6.1 6.7 10.6 12 6.5

Bulgaria 62.1 123 1082.9 22.3 0.3 10.1 7.4

determinants of inflation in romania student: covrig nicolae supervisor: prof. moisĂ altĂr

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