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I would like to thank Charles Adams, Vivek Arora, John McDermott, Aasim Husain, Marianne Schulze-Ghattas, and Anoop Singh for helpful discussion and suggestions.
The cycles have been dated using the growth rate of real GDP, with a cycle assumed to start in the first year of increasing growth and end in the last year of decreasing growth. The exception is 1986, where the turnaround in activity in the middle of the year was taken as the beginning of the third cycle.
The paper focuses on developments in the RPI, which includes the prices of consumer goods sold at the retail level and reflects overall retail sales. The RPI offers a relatively consistent time series of considerable length, appropriate for a study of inflation over the longer term. A consumer price index (CPI)—also referred to as the cost of living index—is published as well, but a shorter time series is available. The CPI is derived from a consumer survey and reflects a typical consumption basket, including services, which are not covered by the RPI. The RPI and CPI have shown broadly similar movements over the past few years, although the CPI measure of inflation generally has been higher, reflecting the relatively faster-rising prices of services. The weights in the indices are not published, although it is estimated that food items make up about half of both the CPI and the RPI. Services are estimated to make up only about 10 percent of the CPI, reflecting the fact that many service items—such as housing and health care—are not marketed, but are provided through an employee’s place of employment.
The sacrifice ratio is defined as the annual real GDP that must be forgone to reduce inflation by 1 percentage point.
Potential output was estimated using a Hodrick-Prescott (HP) filter, with the smoothing parameter chosen to minimize a global error criterion. The growth in potential output and the associated output gap—defined as the difference between actual and potential output in percentage points—are shown in Chart 1. For a discussion of potential pitfalls of this procedure, see below.
The Phillips curve, expressed here as a relationship between inflation and the output gap, can also be applied to wage inflation, in which case the “gap” is between the actual rate of unemployment and the natural rate of unemployment, or NAIRU.
Coe and McDermott (1997) test the model of equation (1) econometrically for a number of Asian economies, and find that Chinese data do not appear to fit the model, most likely as a result of data limitations. Section IV will return to this issue.
If inflationary expectations depend on a distributed lag of past inflation rates, equation (3) would have a more complicated lag structure.
This is one aspect of a more general problem with the measurement of the output gap. Any shock that affects the demand side of the economy could affect the supply side as well, rendering the effect on the output gap and inflation ambiguous. This problem is especially relevant in an economy like China, where structural reform measures may have a wide-ranging impact.
Hu and Khan’s time series ends in 1994; the estimates for 1995 and 1996 were derived using the method described in their paper. The trend capital stock was derived using the Hodrick-Prescott filter.
Taking into account the share of retail sales conducted at free-market prices in 1985—34 percent—a simple calculation using a weighted average implies a rise in administratively set and guided prices of around 2 percent.
Ideally, the exercise would examine equation (1) directly, but since no information is available on inflationary expectations, the simplifying assumption of adaptive expectations will be employed.
As in Coe and McDermott, the Schwarz criterion was used to determine the number of lags on the output gap as an explanatory variable.