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Daniels and VanHoose (2006) discuss several product and labor market characteristics that would contribute to differences in inflation dynamics.
At least as a first order of approximation, the methodology adopted also has the advantage that it removes the influence of a country’s consumption structure.
These findings also allow more nuanced interpretation of inflation persistence. Some part of this persistence is due to “inherited” inflation, in as much as inflation drivers—the output gap and labor costs—are themselves persistent. However, an important component of persistence is “intrinsic” to the catch-up process, which includes product market integration, the Balassa-Samuelson effect, and quality convergence of consumer baskets (Hanousek and Filer 2004 and Hoffmann 1998).
In contrast, Romer (1993) concludes that trade openness directly lowers inflation. More rapid growth in government expenditure also appears associated with higher inflation, though its high correlation with the output gap and wage inflation renders the estimates imprecise (see Froot and Rogoff 1991).
Even earlier, Ball (1994) cautioned about the potency of demand management in containing inflation. He calculated average sacrifice ratios (total loss in output per one percentage point inflation reduction) for the old EU members of 0.2-2.5 over 1-10 years. The sacrifice ratio increases with wage inflexibility. The ratios for Greece, Portugal, and Spain reported in Section 4 of this paper range from 2.2 to 2.6 over 2-5 years.
Absent the restrictions, sets of dummy variables are perfectly collinear. Thus, a linear combination of all prod(j) and time(s) dummies yields the dummy prod_time(j,s). Of the 2I+2T+N+1 restrictions imposed below, 2I+2T+N−1 are linearly independent. One of the I+T restrictions on the averages of prod_time(j,s) is a linear combination of the other restrictions and, hence, not linearly independent. The same holds for one of the N+T restrictions on cy_time(m,s).
We compute this ratio for each month for each country. Then we average the monthly values over a country and finally compute the average once again for the country group reported.
Cross-country inflation differentials among EMU members narrowed until the creation of the EMU in 1999, then widened again, and have stabilized since 2002. Busetti et al. (2006) identify three clusters of countries with low, medium, and high inflation. The cross-country inflation differentials mainly reflect differentials in nontradables (ECB 2003, Altissimo et al., 2005). They have been attributed to differences in nominal effective appreciation (Honohan and Lane, 2003, Lane, 2006), output gap differentials (Honohan and Lane, 2003, Angeloni and Ehrmann, 2004), structural differences in relative price levels, trade openness, oil intensity, and price and wage rigidities (ECB, 2003, Bulíř and Hurník, 2006).
Rudd and Whelan are particularly critical of using “leading” inflation as a proxy for “inflation expectations,” as in Gali and Gertler (1999). They note that leading inflation is typically instrumented by lagged right-hand side variables, which should belong to the main equation itself rather than be used as instruments. Moreover, if empirically relevant, the instruments only emphasize the importance of lagged and persistent effects rather than of expectations. More fundamentally, Mankiw, Reis, and Wolfers (2004) highlight divergent inflation expectations in the population. The comovement of these disagreements with macroeconomic variables implies a theoretical perspective quite different from the sticky price models.
Woodford (1999) identified a proportional relationship between the output gap and real marginal cost under specific assumptions about technology and factor markets.
Chen, Imbs and Scott (2006) find a significant effect of the volume of sectoral trade on the relative price of goods in that sector (for a sample of seven eurozone countries in the earlier period to 1999). However, they conclude that the effect of openness on overall inflation is probably not significant.
Only for the four most open eurozone economies (Belgium, Netherlands, Ireland, and Luxembourg) unit labor cost growth is entirely offset by trade openness to yield an insignificant overall effect for unit labor cost.
Column 5 shows that the results for Eastern non-eurozone are qualitatively the same but statistically stronger than those for the full non-eurozone sample.
Based on Balassa-Samuelson effect, Buiter (2004) argued that the inflation rate in the central and eastern European new members of the European Union (the CEE-8) will raise inflation rates up to 2½ percentage points above EU average inflation. Other studies estimate smaller sizes of the Balassa-Samuelson effect (for a recent review, see Egert, Halpern and MacDonald, 2005). While we also project that the CEE-8 will tend to have higher inflation than the EU average, this would be due more to price convergence rather than merely to productivity differences between traded and non-traded goods sectors.
In addition, the scope for efficiency gains in such non-traded sectors as telecommunications and financial services may have been higher. But the one-time gains have likely run their course.
Studies have found that the business cycles of the Baltics, Latvia and Lithuania, were only weakly correlated with the eurozone cycle while business cycles in Hungary, Slovenia and Poland were closely correlated with that of the eurozone even before their EU accession in May 2004 (e.g., Boreiko, 2003, Fidrmuc and Korhonen, 2004, Artis et al., 2004). With greater integration, the cycles could become more coordinated. There has certainly been convergence in price levels and inflation among the CEE-8 and the EU average.
This may explain the concern expressed by Angeloni e. al (2004) that the Honohan and Lane (2003) results for the eurozone may not be robust. With increasing trade integration in the eurozone, trade baskets have become more similar over time (the standard deviation of nominal effective appreciation across eurozone countries declined, on average, from 0.9 in the first half to 0.4 percent in the second half), leaving limited variability to explain country-specific inflation in the second half of the sample.
The description is based on various reports on Article IV consultations by the International Monetary Fund for these four countries.