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Prepared by E. Faal.
The study period was chosen to exclude the turbulent period leading to the 1994–95 crisis and its aftermath, and to also coincide with period of the authorities’ disinflation program.
Taylor (2000) suggests that the level of exchange rate pass-through declines as the level of inflation is lower, mainly because the pricing power of firms is eroded.
Baqueiro, Diaz-Leon, and Torres (2003) found that the level of exchange rate pass-through weakens as inflation falls.
Zapata (1992) observes that the rate of unionization in state enterprises was close to 100 percent since the Federal Labor Law fostered unionization among state workers.
Under the current system of wage setting, indexation of wages to a cost of living measure does not occur regularly, unless explicitly allowed by specific contracts.
Various studies, including Dwyer and Lam (1994), find a tendency for firms to partially but not fully absorb the effects of currency depreciation.
Ball and Mankiw (1994 and 1995) also argue that firms react proportionately more to large price shocks than to smaller ones. This is because they face adjustment costs, and would therefore be more inclined to change prices in response to large shocks than small shocks.
See Chadha, Masson, and Meredith (1992) for a discussion of the rationale for including both forward- and backward-looking components of the inflation process.
Defining shocks in this way avoids the potential problems of regressing inflation on its own components.
The latter is highly correlated with both quarterly and annual GDP— a regression of IGAE on quarterly GDP yields a coefficient of 0.9, and the fraction of variance of GDP explained by the regression is about 90 percent.
This restriction easily passes a Wald test.
The model can also be used to explore the linkages between wage and price inflation and the appropriate response of monetary policy. To do so requires augmenting the model with a policy reaction function, such as a Taylor rule, or an objective function for policy.