APPENDIX I.1 Data Sources and Definitions
This appendix describes data sources and definitions used in the model of inflation in the United Kingdom for 1981:Q1-2004:Q3.
Inflation (π): Quarterly inflation on annual basis, calculated from CPI index, seasonally adjusted. Data prior to 1988 have been extrapolated using the historical estimates published in the Office for National Statistics (ONS) Economic Trends No. 541 (December 1998). Data source: ONS.
Import prices (Pm): Quarterly changes on annual basis calculated from import price index for total trade in goods; not seasonally adjusted as there are no statistically significant seasonal factors using a standard X12 technique.
Real exchange rate (REER): Based on unit labor costs. The moving average process is calculated using year-on-year changes over the lag period.
Inflation target (π*): 1.7 percent from 1993 to 2003, following the adoption of inflation targeting in 1992, and 2 percent in 2004.
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Prepared by Keiko Honjo.
Including China, Hong Kong SAR, Malaysia, Philippines, South Korea, Singapore, Taiwan, and Thailand.
See the Appendix for an explanation of the data set used.
An alternative estimate of inflation persistence (or inertia), derived from an estimated autoregressive model of inflation, suggests a gradual decline in persistence over time; however, it remains considerable.
Ericsson and Irons (1994) show that the lack of significant empirical evidence supporting the Lucas critique indicates that it may still be valid to use reduced-from models for empirical estimation.
Most other studies looking at the long-term effects of competitiveness use the real exchange rate with a four-quarter lag.
The operator Δ denotes a one-quarter change and Δ4 four quarter changes. All quarterly changes are on annual basis.
The coefficient Φ is related to the average time required by the monetary authorities to eliminate any deviation between observed inflation and the inflation target. In general, it takes the monetary authorities around six to eight quarters to achieve the inflation objective after a shock. This study assumes Φ =0.5, which is consistent with the range suggested by Laxton and N’Diaye (2002) and Batini and Nelson (2002).
Standard tests for a structural break in the CPI equation suggest that such a break might exist in the early 1990s, which would be consistent with a prior expectation of a change in inflation expectations with a shift from a deflationary to a stable inflation environment. A CPI equation estimated over the period from 1992 to 2004 indicates that the explanatory power of the forward-looking component of inflation expectations increases significantly, particularly in gearing inflation towards the target; inflation persistence, however, continues to play an important role in slowing the rise in inflation.
The WEO projects 12-month change import prices to rise gradually from just above zero in 2004Q3 to about 2 percent by the end of 2007.
While there are large uncertainties associated with estimates of the output gap, the widely accepted view in the United Kingdom is that the economy is operating in the neighborhood of full capacity.