Determinants of Inflation in Romania DETERMINANTS OF INFLATION

Determinants of Inflation in Romania DETERMINANTS OF INFLATION IN ROMANIA Student: COVRIG NICOLAE Supervisor: Prof. MOISĂ ALTĂR DOFIN, Bucharest, June 2002

The facts. . . Determinants of Inflation in Romania Inflation in CEE transition economies (annual percentage change) DOFIN, Bucharest, June 2002 2

Determinants of Inflation in Romania 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 DOFIN, Bucharest, June 2002 3

Determinants of Inflation in Romania 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 4

Determinants of Inflation in Romania …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 5

Determinants of Inflation in Romania Modelling Approach Cointegration analysis (in level of variables) MONEY MARKET LABOUR MARKET Deviation from long-run equilibrium (lagged one period) FOREIGN EXCHANGE MARKET Sample: 1996: 01 – 2002: 02 VAR MODEL Short term dynamics of endogenous variables RELATIVE PRICE ADJUSTMENTS ADMINISTRATIVE DECISIONS ABOUT PRICES Frequency: monthly Exogenous variables DOFIN, Bucharest, June 2002 6

Determinants of Inflation in Romania LONG RUN EQUILIBRIUM ON THE MONEY MARKET Theoretical 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 7

Determinants of Inflation in Romania LONG RUN EQUILIBRIUM ON THE MONEY MARKET Choice of variables for Romania case (1/8) Monthly observation for M 2 XR where M 2 XR = M 2 R – resident’s foreign currency deposits Seasonally adjusted time series was use M 2 XR is I(1) DOFIN, Bucharest, June 2002 8

Determinants of Inflation in Romania LONG RUN EQUILIBRIUM ON THE MONEY MARKET Choice of variables for Romania case (2/8) THE CHOICE OF M 2 XRSA WAS JUSTIFIED BY: the strong correlation between M 1 R and M 2 XR the intention to capture the monetary substitution the greater volatility in M 2 XR the avoidance of portfolio reallocation due to financial innovation DOFIN, Bucharest, June 2002 9

Determinants of Inflation in Romania LONG RUN EQUILIBRIUM ON THE MONEY MARKET Choice 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 M 2 XR DLEXUSD ~ I(0) or I(1) taking into account the structural break DOFIN, Bucharest, June 2002 10

Determinants of Inflation in Romania LONG RUN EQUILIBRIUM ON THE MONEY MARKET Johansen cointegration analysis (4/8) REMARK: DUMMY 9703 included – cointegration test possibly affected 2 LAGS IN VAR DOFIN, Bucharest, June 2002 11

Determinants of Inflation in Romania LONG RUN EQUILIBRIUM ON THE MONEY MARKET Johansen cointegration analysis (5/8) LM 2 XRSA Unrestricted cointegrating coefficients for: -0. 28985 Normalized cointegrating coefficients for: -1. 0000 Adjustment coefficient for YSA 0. 37313 0. 00876 96 0. 030255 (0. 42922) (0. 00430) [-2. 99916] [-7. 03754] 1. 2873 -0. 025066 0. 016445 DOFIN, Bucharest, June 2002 DR 5. 244893 DLEXUSD Intercept 0. 002787 1 2. 4736 -. 0096157 8. 5340 (0. 00219) (0. 17448) [ 4. 38687] [-48. 9117] -0. 95072 12

Determinants of Inflation in Romania LONG RUN EQUILIBRIUM ON THE MONEY MARKET Johansen cointegration analysis (6/8) DOFIN, Bucharest, June 2002 13

Determinants of Inflation in Romania LONG RUN EQUILIBRIUM ON THE MONEY MARKET Statistics for Johansen cointegration analysis (7/8) DOFIN, Bucharest, June 2002 14

Determinants of Inflation in Romania LONG RUN EQUILIBRIUM ON THE MONEY MARKET Error correction term (8/8) The large disequilibria are strongly related to the nominal exchange rate depreciations and to the nominal deposit rate increase DOFIN, Bucharest, June 2002 MODELLING APPROACH 15

Determinants of Inflation in Romania LONG RUN EQUILIBRIUM ON THE LABOUR MARKET Theoretical consideration Real wage W/P is a mark-up over the labour productivity LP where and P – level of price E - employment W – net nominal wage Y - output DOFIN, Bucharest, June 2002 16

Determinants of Inflation in Romania LONG RUN EQUILIBRIUM ON THE LABOUR MARKET Variable evolution ALL VARIABLES ARE I(1) DOFIN, Bucharest, June 2002 17

Determinants of Inflation in Romania LONG RUN EQUILIBRIUM ON THE LABOUR MARKET Johansen cointegration test REMARK: SEASONAL CENTERED DUMMIES WERE INCLUDED DUMMYDEC and DUMMYJAN; DOFIN, Bucharest, June 2002 10 LAGS IN VAR 18

Determinants of Inflation in Romania LONG RUN EQUILIBRIUM ON THE LABOUR MARKET Johansen cointegration test Variable LWAGR LLP Normalized adjustment coefficient for: 0. 287776 0. 76683 0. 21153 0. 370434 0. 24230 0. 25253 [ 4 [0. 77686] [0. 83762 3. 16475 ] ] Normalized cointegrating DOFIN, Bucharest, June 2002 -1. 0000 LMARK UP Trend Intercept 1. 07563 0. 69167 -0. 05966 0. 00222 0. 099123 19

Determinants of Inflation in Romania LONG RUN EQUILIBRIUM ON THE LABOUR MARKET Additional statistics DOFIN, Bucharest, June 2002 20

Determinants of Inflation in Romania LONG RUN EQUILIBRIUM ON THE LABOUR MARKET Additional statistics DOFIN, Bucharest, June 2002 21

Determinants of Inflation in Romania LONG RUN EQUILIBRIUM ON THE LABOUR MARKET Error correction term (8/8) MODELLING APPROACH DOFIN, Bucharest, June 2002 22

Determinants of Inflation in Romania 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 quality improvements - the Balassa-Samuelson effects DOFIN, Bucharest, June 2002 23

Determinants of Inflation in Romania RELATIVE PRICE ADJUSTMENTS (2/7) 35 classes of goods and services in the CPI structure DOFIN, Bucharest, June 2002 24

Determinants of Inflation in Romania RELATIVE PRICE ADJUSTMENTS (3/7) DOFIN, Bucharest, June 2002 25

Determinants of Inflation in Romania RELATIVE PRICE ADJUSTMENTS (4/7) Highest price changes between 1997 and 2002 Smallest price changes between 1997 and 2002 DOFIN, Bucharest, June 2002 26

Determinants of Inflation in Romania RELATIVE PRICE ADJUSTMENTS (5/7) DOFIN, Bucharest, June 2002 27

Determinants of Inflation in Romania RELATIVE PRICE ADJUSTMENTS (6/7) High skewned distribution DOFIN, Bucharest, June 2002 28

Determinants of Inflation in Romania RELATIVE PRICE ADJUSTMENTS (7/7) MODELLING APROACH DOFIN, Bucharest, June 2002 29

Determinants of Inflation in Romania ADMINISTRATED PRICES Twelve month percentage change DOFIN, Bucharest, June 2002 30

Determinants of Inflation in Romania ADMINISTRATED PRICES “Net inflation” (1) DOFIN, Bucharest, June 2002 31

Determinants of Inflation in Romania ADMINISTRATED PRICES “Net inflation” (2) DOFIN, Bucharest, June 2002 32

Determinants of Inflation in Romania ADMINISTRATED PRICES “Net inflation” (3) Autonomous inflation: 27, 99 % per annum Inflation inertia: DOFIN, Bucharest, June 2002 0. 19 33

Determinants of Inflation in Romania ADMINISTRATED PRICES “Net inflation” (4) MODELLING APPROACH DOFIN, Bucharest, June 2002 34

Determinants of Inflation in Romania SHORT RUN DYNAMICS OF INFLATION (1/7) • Unrestricted vector autoregression with one lag and: – Endogenous variables : • DLCPI (inflation rate) • DLM 2 XR (the change in real M 2 XR) • 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) DUMMY 9605, DUMMY 9612, DUMMY 9701, DUMMY 9905 DOFIN, Bucharest, June 2002 35

Determinants of Inflation in Romania SHORT RUN DYNAMICS OF INFLATION (2/7) DOFIN, Bucharest, June 2002 36

Determinants of Inflation in Romania SHORT RUN DYNAMICS OF INFLATION (3/7) DOFIN, Bucharest, June 2002 37

Determinants of Inflation in Romania SHORT RUN DYNAMICS OF INFLATION (4/7) Impulse response function DOFIN, Bucharest, June 2002 38

Determinants of Inflation in Romania SHORT RUN DYNAMICS OF INFLATION (5/7) Variance decomposition DOFIN, Bucharest, June 2002 39

Determinants of Inflation in Romania SHORT RUN DYNAMICS OF INFLATION (6/7) Parsimonious model DOFIN, Bucharest, June 2002 40

Determinants of Inflation in Romania SHORT RUN DYNAMICS OF INFLATION (7/7) Parsimonious model DOFIN, Bucharest, June 2002 41

Determinants of Inflation in Romania 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 42

Determinants of Inflation in Romania 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 43

Determinants of Inflation in Romania The facts. . . Consumer Price Index (average annual change in %) 1995 1996 1997 1998 1999 20001 Romania 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 DOFIN, Bucharest, June 2002 44