Phillips Curve Estimation for Latvia

1
Phillips Curve Estimation for Latvia

• Aleksejs Melihovs, Anna Zasova
• 2007

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The motivation

• Improvement of understanding of the inflation
  formation mechanism
• Testing what type of Phillips Curve model is
  better for the Latvian reality
• Understanding what type of inflation expectations
  is more important for Latvian inflation dynamics.

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Estimated Models

• Three types of Phillips Curve models have been
  estimated
• Traditional
• New Keynesian and
• Hybrid.
• Every type of Phillips Curve models has been
  modelled for two cases closed and open economy.

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Phillips Curves open economy case
? inflation E expectation operator Y
business cycle X external factors vector

• Traditional Phillips Curve

• New Phillips Curve

• Hybrid Phillips Curve

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Variables

• Inflation
• core inflation (CPI excluding administrative,
  energy and non-processed food prices)
• Business cycle (two alternative indicators)
• GDP gap (HP filter),
• unemployment gap (HP filter).
• Exogenous variables for open economy models
• producer prices in main foreign trade partner
  countries,
• nominal effective exchange rate.

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Why core inflation not CPI?

• National Banks tend to focus on core inflation
  because
• it excludes highly volatile factors
• measures of core inflation capture the permanent,
  or long run trend in CPI
• core inflation is generally associated with
  expectations and demand pressure components of
  measured inflation and excludes supply shocks.

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Core inflation vs CPI inflation
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Why business cycles not marginal production costs
and foreign producer prices not import prices?

• Too short time series for MPC
• data is available only from 1999
• unemployment rate and GDP data from 1995
• for such short time series three years make a big
  difference!
• The same story is for import price statistics in
  Latvia
• as Latvia is a price taker, foreign producer
  prices are viewed as second best for import price
  approximation.

9
Business Cycles
Recovery after the Banking crisis
Recovery after the Russian crisis
Rapid growth
A sharp fall in oil transit
Banking crisis
Russian crisis
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Exogenous Factors
q-o-q,
Russian crisis
Correction in world financial markets
Re-pegging form SDR basket to Euro
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Estimation Technique

• GMM
• Instrumental variables are
• core inflation,
• GDP gap,
• unemployment gap,
• NEER and
• foreign producer prices (lagged from -1 to -3)
• Expectations are replaced with realizations.

Lagged from -1 to -3.
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Estimated results for Traditional Phillips Curve
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Estimated results for New Phillips Curve
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Estimated results for Hybrid Phillips Curve
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Hybrid Phillips Curve structural model with
coefficient normalization
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Conclusions (I of II)

• In Latvian inflation dynamics the weights of
  lagged and future expected inflation are found to
  be roughly equal (similar to, e.g., Hungary)
• This suggests that inflation in Latvia has more
  inertia, as compared to the Euro area or USA
  (according to GG 2001 in Euro area and USA lagged
  inflation matters much less for their inflation
  dynamics)

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Conclusions (II of II)

• At the same time, price adjustments in Latvia are
  estimated to take place more often than in the
  Euro area and USA approximately once in 6
  months on average.
• According to GG 2001 in Euro area this period is
  about 3 years and in USA approximately 1.5
  year.