Appendix: VAR Methodology
We examine the sources of inflationary pressures in Uruguay using a six variable recursive vector autoregressive (VAR) model to isolate the impact of domestic and external shocks on domestic consumer prices. This approach captures the dynamic structure underlying the interaction between strictly exogenous world fuel and food commodity price shocks, as well as (endogenous) economic activity, the exchange rate, monetary policy and domestic consumer prices. The model simultaneously regresses each endogenous variable on lags of itself and all other variables in the model. The underlying recursive structure of the variance-covariance matrix allows for identification of shocks stemming from external and domestic developments, and estimation of their effects on consumer prices.
VAR models have been widely used in the literature analyzing the response of an economy to commodity price shocks. Recent studies include De Gregorio, Landerretche and Neilson (2007) and Pincheira and Garcia (2007) who analyze the effects of oil shocks on inflation in Chile; Blanchard and Gali (2007) who explain changes over time in the macroeconomic effects of oil shocks in industrialized countries; and Mishkin and Schmidt-Hebbel who analyze the macroeconomic effects of external shocks under inflation targeting.
A VAR approach is relevant for analyzing a phenomenon, such as rising inflation, without imposing a prior theoretical approach. Hence the approach suits the purposes of the current study given that it does not require necessarily having strong priors about competing explanations for rising inflation, instead allowing the regularities found in the data to tell a story. World fuel and food prices are treated as exogenous variables, and hence assumed to be determined independently of the rest of the system. Ordering of the endogenous variables in the VAR to achieve identification is informed by economic theory and supported by Granger causality tests. Shocks in the system are identified according to the following recursive specification7:
The system incorporates the dynamic effect of a commodity price shock on domestic prices, with shocks affecting prices both directly as well as indirectly via previous stages. The domestic price variable contains the expected inflation at month t, the supply and demand shocks, the exchange rate and monetary policy shocks, as well as shocks due to CPI inflation.
Blanchard, Olivier and Jordí Galí, 2008, “The Macroeconomic Effects of Oil Price Shocks: Why are the 2000s so Different from the 1970s?” NBER Working Paper.
De Gregorio, José, Oscar Landerretche, and Christopher Neilson (2007), “Another Pass-Through Bites the Dust? Oil Prices and Inflation?” Economia.
Duma, Nombuelo, 2008 “Pass-Through of External Shocks to Inflation in Sri Lanka,” IMF Working Paper 08/78 (Washington, D.C.: International Monetary Fund).
Hooker, Mark, 2002, “Are Oil Shocks Inflationary? Asymmetric and Nonlinear Specifications versus Changes in Regime” Journal of Money, Credit, and Banking, 34 (2), 540-61.
Mihaljek, Dubravko, and Marc Klau, 2000, “A Note on the Pass-Through from Exchange rte and Foreign Price Changes to Inflation in Selected Emerging Market Economies” BIS Papers 8, 69–81.
This paper was prepared by Rita Babihuga and Gaston Gelos.
See Gelos and Rossi (2007) and Celasun, Gelos, and Prati (2004).
We also examined the impact on the producer price index (PPI), finding that world food price shocks have a large positive and significant impact on producer prices, with the impulse response of the PPI to an increase in world food prices exceeding, in magnitude and duration, the response of consumer prices to the same shock. As in the case of CPI (¶14), the impact of world fuel prices on the PPI is minimal.
When using a peso-based price index, the initial impact is positive and significant, but after the first quarter, the impulse response looses significance.
Gasoline products account for just under 3 percent of the total CPI basket.
On average, this would be equivalent to a 0.5 percentage point increase (decrease) in the unemployment rate.