DETERMINANTS OF INFLATION IN ROMANIA

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DETERMINANTS OF INFLATION IN ROMANIA

• Student COVRIG NICOLAE
• Supervisor Prof. MOISA ALTAR

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The facts ...
Inflation in CEE transition economies (annual
percentage change)
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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

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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

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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

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ModellingApproach
Sample 199601 200202 Frequency
monthly
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LONG RUN EQUILIBRIUM ON THE MONEY
MARKETTheoretical 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
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LONG RUN EQUILIBRIUM ON THE MONEY MARKETChoice
of variables for Romania case (1/8)
Monthly observation for M2XR where M2XR M2R
residents foreign
currency deposits
Seasonally adjusted time series was use
M2XR is I(1)
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LONG RUN EQUILIBRIUM ON THE MONEY MARKETChoice
of variables for Romania case (2/8)
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
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LONG RUN EQUILIBRIUM ON THE MONEY MARKETChoice
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 M2XR
DLEXUSD I(0) or I(1) taking into account the
structural break
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LONG RUN EQUILIBRIUM ON THE MONEY MARKETJohansen
cointegration analysis (4/8)
REMARK DUMMY9703 included cointegration test
possibly affected
2 LAGS IN VAR
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LONG RUN EQUILIBRIUM ON THE MONEY MARKETJohansen
cointegration analysis (5/8)
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
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LONG RUN EQUILIBRIUM ON THE MONEY MARKETJohansen
cointegration analysis (6/8)
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LONG RUN EQUILIBRIUM ON THE MONEY
MARKETStatistics for Johansen cointegration
analysis (7/8)
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LONG RUN EQUILIBRIUM ON THE MONEY MARKETError
correction term (8/8)
The large disequilibria are strongly related to
the nominal exchange rate depreciations and to
the nominal deposit rate increase
MODELLING APPROACH
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LONG RUN EQUILIBRIUM ON THE LABOUR MARKET
Theoretical consideration
Real wage W/P is a mark-up over the labour
productivity LP
and
where
P level of price E -
employment W net nominal wage Y -
output
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LONG RUN EQUILIBRIUM ON THE LABOUR
MARKETVariable evolution
ALL VARIABLES ARE I(1)
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LONG RUN EQUILIBRIUM ON THE LABOUR
MARKETJohansen cointegration test
REMARK SEASONAL CENTERED DUMMIES WERE INCLUDED
DUMMYDEC and DUMMYJAN 10 LAGS
IN VAR
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LONG RUN EQUILIBRIUM ON THE LABOUR
MARKETJohansen cointegration test
Variable LWAGR LLP LMARKUP Trend Intercept

Normalized adjustment coefficient for -0.76683 0.242304 -3.16475 -0.21153 0.25253 -0.83762 0.287776 0.370434 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
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LONG RUN EQUILIBRIUM ON THE LABOUR
MARKETAdditional statistics
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LONG RUN EQUILIBRIUM ON THE LABOUR
MARKETAdditional statistics
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LONG RUN EQUILIBRIUM ON THE LABOUR MARKET Error
correction term (8/8)
MODELLING APPROACH
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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
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RELATIVE PRICE ADJUSTMENTS (2/7)
35 classes of goods and services in the CPI
structure
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RELATIVE PRICE ADJUSTMENTS (3/7)
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RELATIVE PRICE ADJUSTMENTS (4/7)
Highest price changes between 1997 and 2002
Smallest price changes between 1997 and 2002
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RELATIVE PRICE ADJUSTMENTS (5/7)
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RELATIVE PRICE ADJUSTMENTS (6/7)High skewned
distribution
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RELATIVE PRICE ADJUSTMENTS (7/7)
MODELLING APROACH
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ADMINISTRATED PRICES
Twelve month percentage change
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ADMINISTRATED PRICESNet inflation (1)
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ADMINISTRATED PRICES Net inflation (2)
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ADMINISTRATED PRICES Net inflation (3)
Autonomous inflation 27,99 per annum Inflation
inertia 0.19
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ADMINISTRATED PRICES Net inflation (4)
MODELLING APPROACH
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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

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SHORT RUN DYNAMICS OF INFLATION (2/7)
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SHORT RUN DYNAMICS OF INFLATION (3/7)
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SHORT RUN DYNAMICS OF INFLATION (4/7)Impulse
response function
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SHORT RUN DYNAMICS OF INFLATION (5/7)Variance
decomposition
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SHORT RUN DYNAMICS OF INFLATION
(6/7)Parsimonious model
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SHORT RUN DYNAMICS OF INFLATION
(7/7)Parsimonious model
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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

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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

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The facts ...
Consumer Price Index (average annual change in ) Consumer Price Index (average annual change in ) Consumer Price Index (average annual change in ) Consumer Price Index (average annual change in ) Consumer Price Index (average annual change in ) Consumer Price Index (average annual change in ) Consumer Price Index (average annual change in ) Consumer Price Index (average annual change in )
1995 1996 1997 1998 1999 2000 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