ERICH SPITÄLLER *
A number of subjects in economics would appear to have been worked over so thoroughly that any new attempt to address them is likely to be suspect of treading old ground and rehearsing familiar arguments. This is certainly true of inflation. The literature abounds in studies of wage and price movements, and to undertake yet another study in this area requires justification. On a general level this is easily done: identifying the causes of inflation is a perennial and elusive problem, requiring frequent re-examination. Recent developments bear this out. Together with the relatively high levels of unemployment, inflation has been and continues to be among the main preoccupations of economic authorities in many countries. At the same time, the view is spreading that in the 1970s the process of inflation has undergone a number of structural changes and is therefore different from what it was in earlier years. Coincidentally, a rapidly growing body of literature has developed a new—although seriously contested—approach to the analysis of inflation, combining the so-called aggregate supply theory of Friedman and Phelps with the application of “rational” expectations to the labor market. The attention that this approach has attracted makes it necessary that any new study of inflation take it into account.
This paper is organized along the following lines. The theoretical section develops a model explaining price changes and discusses its properties with reference to recent work on inflation. The empirical section presents results from the estimation of reduced form price equations for the seven main industrial countries—Canada, France, the Federal Republic of Germany, Italy, Japan, the United Kingdom, and the United States—based on data from 1958 to 1976. The concluding section summarizes some of the distinctive features of the model and the main empirical findings.
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)| false Hamburger, Michael J., and Rutbert D. Reisch, “Inflation, Unemployment and Macro-economic Policy in Open Economies: An Empirical Analysis,”in Institutions, Policies and Economic Performance, ed. by Carnegie-Rochester Conference Series on Public Policy, A Supplementary Series to the Karl Brunnerand Allan H. Meltzer, Journal of Monetary Economics, Vol. 4( Amsterdam, 1976), pp. 311- 38. (This book is referred to hereinafter as Institutions, Policies and Economic Performance.)
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)| false Komiya, Ryutaro, and Yoshio Suzuki, “Inflation in Japan,”in Worldwide Inflation: Theory and Recent Experience, ed. by Lawrence B. Krauseand Walter S. Salant, The Brookings Institution( Washington, 1977), pp. 303- 48. (This book is referred to hereinafter as Worldwide Inflation.)
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)| false Korteweg, Pieter, “The Economics of Inflation and Output Fluctuations in the Netherlands, 1954-1975: A Test of the Dominant Impulse-Cum-Rational Expectations Hypothesis,”presented at the Carnegie-Rochester Conference Series on Public Policy, April 15-16, 1977.
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)| false Kwack, Sung Y., “The Effect of Foreign Inflation on Domestic Prices and the Relative Price Advantage of Exchange-Rate Changes,”in The Effects of Exchange Rate Adjustments: The Proceedings of a Conference Sponsored by OASIA Research, Department of the Treasury, April 4 and 5, 1974, ed. by ( Peter B. Clark, Dennis E. Logue, and Richard James Sweeney Washington, 1974), pp. 387- 98. (This book is referred to hereinafter as The Effects of Exchange Rate Adjustments.)
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Mr. Spitäller, economist in the External Adjustments Division of the Research Department, is a graduate of the University of Graz, Austria, and of the School of Advanced International Studies of the Johns Hopkins University, Washington, D. C. He was formerly on the staff of the Organization for Economic Cooperation and Development.
In view of the definition of the output gap as Y/Ȳ, references to an increase, or a fall, in the gap are to be understood throughout this paper as an increase or a fall in the ratio of actual output to capacity output.
Experiments were made using a slope dummy on the output gap. This dummy would carry the value of +1 or -1, depending on whether the value of the output gap exceeded or fell short of unity. No results consistent with these particular assumptions were obtained.
Together, equations (4) and (5) imply that expectations are formed “semirationally.” In the long run, expectations conform to price changes in long-run equilibrium. In the short run, expectations gradually adjust toward their long-run value. See, for example, Knight (1976), pp. 8-9, and Mathieson (1977), pp. 15ff.
This may be seen rewriting the right-hand side of equation (9) as
Equation (10) is one formulation of Okun’s Law used in his 1962 study; see Okun (1962). It embodies the restrictive assumption that all changes in the output gap necessarily involve changes in unemployment in the opposite direction.
For a discussion of the influence of import price changes in the inflation process relative to the import content of total demand, see Goldstein and Officer (1977).
See the recent review by Gordon (1977 a). For a critique of empirical tests of the aggregate supply theory, see Arak (1977) for her comments on the work of Lucas (1973). She also obtains results that are inconsistent with the theory: in the United States, errors in price expectations do not bear a significant relationship to variations in output. For a reply to Arak’s criticism, see Lucas (1977).
Modigliani illustrates this difference in terms of the explanation that demand pressure (excess employment) causes inflation and the contrasting view that the unexpected component of inflation causes excess employment. See Modigliani (1977).
For a most comprehensive and penetrating assessment of the role of rational expectations in economic models, see Poole (1976).
The superiority of the rational expectations scheme is argued in Hamburger and Reisch (1976); for a critique, see Poole (1976). The empirical tests of this scheme by Fratianni (1977) and Korteweg (1977) are criticized by Argy (1977 a).
For the argument that import price changes affect inflationary expectations, see Laidler (1976 a; 1976 b). However, he finds that world price changes perform even better in this connection than do import price changes. On the role of world price changes, see also Genberg (1976).
Recent references to the effects of foreign price and exchange rate changes on inflation in general include Kwack (1974), Crockett and Goldstein (1976), Sweeney and Willett (1974; 1976), Dornbusch (1976), and Dornbusch and Krugman (1976).
The significance of monetary changes in the context of inflationary expectations is also pointed out in Towards Full Employment and Price Stability: A Report to the OECD by a Group of Independent Experts (1977), Ch. 2, pp. 108-10. See also Artus and Crockett (1977), Bilson (1978 a; 1978 b), Dornbusch (1976), and Dornbusch and Krugman (1976). These studies analyze the more indirect link of monetary changes and inflation. Monetary expansion would—through its effect on interest rates—bring down the exchange rate. As a result, inflationary expectations would rise and inflation would accelerate.
The proposition applies to a closed economy because domestic and general price levels are the same, and a10 therefore equals unity. It applies to an open economy under either fixed or flexible rates on account of purchasing power parity in equilibrium; under a fixed rate, inflation at home adjusts to inflation abroad, while under a flexible rate it is the exchange rate that adjusts. All the same, however, the long-run policy implications of equation (15) differ in individual cases. In a closed economy and in an open economy under a flexible rate, changes in money are exogenous, and the country can have the inflation that it wants. Under a fixed rate, inflation cannot be controlled by the domestic authorities because they can affect only the domestic component of base money, not its reserve component. None of this is new, and it is mentioned only to show that the reduced form equations derived in this paper are consistent in long-run equilibrium with the fundamental quantity theory.
The last term
The rationale for this may be briefly set out with reference to the adaptive process that expectations about changes in the money stock were assumed to follow. Recalling its lag operator form as given in equation (7″) but including this time an error term, that process reads
where the error term, u, is normally and independently distributed with zero mean and constant variance. Equation (18) can be written as
An equation the right-hand side of which is expressed as in (19′) may be estimated—after truncation—nonlinearly, subject to certain restrictions.
Equation (18) may be rewritten with linear parameters as
where ν = u–(l–λ)u-1
This new error term, ν, is serially correlated because it is subject to a first-order moving average process. The same is true of the error terms in the reduced forms of the model, since their derivation involves relations (18) and (20). Serial correlation in the error term poses a particular problem in a model that contains the lagged dependent variable among its arguments, like the reduced form equations considered here. The reason is that in the circumstances the standard assumption of independence of the error term is no longer warranted. This is demonstrated in equation (20) where both
The moving average process ν = u–(1–λ)u-1 may be transformed into an autoregressive process, which may be written in the form of
Truncating after the first term, equation (21) may be written as
where ρ is the coefficient of autocorrelation and ∊ is assumed to be an error term with zero mean and constant variance.
Hence, the reduced form equations of this paper are estimated subject to a first-order autoregressive process.
Inflation was measured in terms of consumer prices and output in terms of industrial production in manufacturing on grounds of the availability of data. Sufficiently long series on quarterly data of real gross domestic product—which might be considered a better measure of output in this context—are not available for all countries.
In Japan, the consumer price index reflects conditions in the traditional economy and does not move in line with economic activity in general. By contrast, wholesale prices are cyclically sensitive; authorities react to inflation as measured by the wholesale price index and not the consumer price index. Authorities can exert tight control over commerical bank lending, and changes in Ml have been an even better empirical indicator of money conditions than changes in M1. See Komiya and Suzuki (1977) and the comments by Krause (1977 b).
This is an impression that is supported to some extent by results from estimates that were obtained for different subperiods but that are not reported here in detail. For example, an estimate of the price change equation for the Federal Republic of Germany over the period 1958-69 reads:
A similar pattern applies to Italy, but only in estimates using annual observations. An annual price equation for the years 1959-76 reads:
No pretense is made of an in-depth analysis of these various disturbances. Their apparent insignificance in the present model cannot be considered definitive. Contrasting results may, for example, be found in the studies of wage movements in Modigliani and Tarantelli (1977) for Italy and in Spitäller (1976) for the other countries.
See Gatz (1963), Dornbusch and Krugman (1976), Emminger (1977), and Goldstein (1977). Dornbusch and Krugman suggest that the insignificance of import price changes may be attributable to arrangements in the European Economic Community, which tend to offset effects of exchange rate changes on the prices of agricultural imports. Gatz claims that—referring to the 1961 revaluations—reductions in the deutsche mark price are not passed on. In this vein, Goldstein finds some evidence of a ratchet effect—a proportionately larger effect of devaluations on inflation than of revaluations. Emminger points out that the experience in this connection has not been consistent with respect to different revaluation episodes.
The reasons for such a change in adjustment speed are not explored here. But this change has coincided with an acceleration of inflation in most countries. Khan (1977 a; 1977 b) found that—at least in situations of hyperinflation—the speed of adjustment varied in direct proportion to the rate of inflation. The desire for protection from the losses caused by progressive monetary erosion is offered as an explanation.