Inflation models for the Euro area

In Section 8.3 we found that an inverted money demand function did not pro­vide a sound basis for explaining inflation in the Euro area. Still, there may be a case for models of inflation that conceive of inflation primarily as a monetary phenomenon. In this section, we compare and evaluate four inflation models which have been used to analyse data for the Euro area. These include the P*-model, which relates the steady-state of the price level to the quantity theory of money, a hybrid New Keynesian Phillips curve model (NPCM) of inflation (see Chapter 7) and two reduced form inflation equations: one derived from the dynamic version of the Incomplete Competition Model (ICM) we developed in Chapters 5 and 6, and the other from the wage-price block of the AWM of the European Central Bank.


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Ex post calculated interest rate rules

To get a feel for the properties and implications of the different monetary policy rules in Table 10.1, we have calculated ex post interest rates corresponding to the different rules, by inserting the actual outcomes of the variables into the various versions of equation (10.1). The results are shown in the four charts in Figure 10.3. The upper left panel shows the realised interest rate together with the implied interest rate of following the flexible rule FLX. Following the rule would have meant a much higher interest rate during 1997, as a consequence of the spurt in output growth, shown in Figure 10.2(b). The strict rule ST of the upper right panel is basically reflecting the development of underly­ing inflation of Figure 10.2(a), while the smoothing rule SM appears more

image212 image213


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Summary of findings—Euro-area data

The model comparisons in this section do not allow us to draw decisive conclusions. Some caveats no doubt apply: the presumptions of a clearly defined monetary policy for the economy under study, which are underlying the P*-model as it is laid out in Gerlach and Svensson (2003), is not favoured by adopting an observation period which starts nearly 30 years before the intro­duction of the Euro.[85] Likewise, the ICM—with its focus on the labour market influx on inflation—is probably a better model description of the national economies than for the Euro area.



— 1-step Forecasts AWM — Dp




— 1-step Forecasts (ICM) — Dp



Pstar model

— Pstar 1-step Forecasts — Dp



Enhanced Pstar model — 1-step Forecasts — Dp




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Revisiting empirical models of Norwegian inflation

The definitions of the variables are in line with those we presented for the ICM in Chapter 9, but the sample is different and covers the period 1966(4)-1996(4). The wage variable wt is average hourly wages in the mainland economy, exclud­ing the North Sea oil-producing sector and international shipping. The produc­tivity variable at is defined accordingly. The price index pt is measured by the official consumer price index. The import prices index pit is a weighted average of import price indices from trading countries. The unemployment variable ut is defined as a ‘total’ unemployment rate, including labour market programmes. The tax-rates t1t and t3t are rates of payroll tax and indirect tax, respectively.6

The output gap variable gapt is measured as deviations from the trend obtai...

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Testing the encompassing implications

So far the NPCM has mainly been used to describe the inflationary process in studies concerning the United States economy or for aggregated Euro data. Heuristically, we can augment the basic model with import price growth and other open economy features, and test the significance of the forward infla­tion rate within such an extended NPCM. Recently, Batini et al. (2000) have derived an open economy NPCM from first principles, and estimated the model on United Kingdom economy data. Once we consider the NPCM for individual European economies, there are new possibilities for testing—since pre-existing results should, in principle, be explained by the new model (the NPCM)...

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Productivity at

Productivity growth Д^ is basically modelled as a moving average with declining weights

Дat = 0.73 — 0.76Д^_ 1 — 0.79Д^_ 2 — 0.48Да^ 3 (0.15) (0.05) (0.05) (0.10)

— 0.18ecmat — 0.06Adumt + 0.08Seasonalt_ 3 (9.10)

(0.04) (0.02) (0.01)

T = 1972(4)-2001(1) = 114

a = 1.52%

Far(i-S)(5, 102) = 0.17[0.97]

X2normality(2) = 1.23[0.54]

FHETx2 (10,96) = 0.74[0.69].

(Reference: see Table 9.2. The numbers in [..] are p-values.)

In the longer run the development is influenced by the real wage, by unem­ployment and by technical progress—proxied by a linear trend—as expressed by the equilibrium correction mechanism

ecmat = at-4 — 0.3(u> — p)t-i — 0.06wt-3 — .002Trend t.

The dummy Adumt = [i86q2]t picks up the effect of a lock-out in 1986(2) and helps whiten the residuals.

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