Factors that contribute to the formation of inflation.
Before going through the nominal rigidities of the economy and how they impede the absorption control, it should be recalled that, in order to achieve two objectives - the control of domestic inflation and the international competitiveness - two policies are needed. The national currency depreciation cannot improve the external position and at the same time, reduce inflation. The second policy should aim at the domestic absorption. The reduction of the domestic absorption through monetary or fiscal contraction is accompanied by the contraction of the demand for non-tradable goods and inflation control, but the price to be paid is higher unemployment. The monetary or fiscal policies, designed for domestic absorption induce the contraction in domestic demand for tradable goods, discouraging the export offer (1).
As long as inflation has persisted it can be inferred that in Romania the absorption reduction policies have not been used to their full capacity. In order to provide an overview on the significant structural factors that have prevented the use of aggressive interest rate to control internal absorption, we use three econometric equations regarding inflation in costs, the compromise between salary rate and employment level and, respectively, the reaction function of the central bank (2).
DESCRIPTIVE EQUATIONS OF THE INFLATIONARY PHENOMENON
The first equation describes the traditional mechanism of inflation by costs. The equation shows the inflationary impact in the failure to correlate labor productivity and wages, as well as the increased cost of imported intermediate consumption as a result of currency depreciation.
[DELTA]p = [a.sub.1]x([DELTA]w - [DELTA]q) + [a.sub.2]x([DELTA]e + [DELTA]pext) (1)
where: p = is the domestic price level (measured by the price index for consumer goods and services)
w = wages (expressed as gross salary including social security contributions)
q = labor productivity
e = nominal exchange rate (indirect quote)
pext = foreign price level (measured by the index of consumer prices of goods and services in the U.S.).
The econometric parameters [a.sub.1] and [a.sub.2] are positive and meet the relation: [a.sub.1] + [a.sub.2] =1 (2)
The second equation shows that the unemployment rate affects the ability of the nominal wage to recover purchasing power, eroded by inflation. The general equation is:
[DELTA]w - [DELTA]pw = [a.sub.3]x[DELTA][u.sub.(-1)] (3)
where: u = unemployment rate.
The econometric parameter [a.sub.2] is negative.
The policy of targeting the exchange rate is described by a reaction function that correlates the depreciation rate with the difference between internal and external inflation. The general equation is:
[DELTA]e = [a.sub.4]x([DELTA]p - [DELTA]pext)[DELTA]e (4)
where: the econometric parameter [a.sub.4] is positive.
The variables upon which the three equations were estimated, have been expressed in logarithms, which means that the first order differences are exactly the change rates of those variables. All variables have been seasonally adjusted and the first order differences were tested for stationarity. Statistical data for the period 2004-2010 has been used, quarterly averages.
The equation (5), shown below, measures, on the offer side, the inflation sources through cost following the model in equation (1).
The estimated equation is a linear combination between wage rates in excess compared to the rate of labor productivity and imported inflation (the rate of nominal depreciation of the RON and foreign inflation rate):
[DELTA]p = 0,39 * ([DELTA]w - [DELTA]q) + 0,61 * ([DELTA]e + [DELTA]pex) (5)
[R.sub.2]=0.47; DW=1,81; t-statistic=3.37
The equation (5) contains the following information: inflation in Romania is created, on the costs side, significantly, both by increasing wages faster than productivity, as well as by RON depreciation. The equation confirms the intuition that wages are a powerful inflationary factor in the economy, operating with weak budget constraints, especially in the relation between the government and NGOs (so salaries could not be an inflationary factor). It also shows that currency depreciation is an inflationary factor 1.6 times stronger than the failure to correlate wages and labor productivity.
The equation (6), which follows, estimates equation (3) for the Romanian economy. Estimates show that wages recover their purchasing power according to labor market pressures. The interpretation of the equation is immediate: if Au. (u is zero, then the wages fully recover the purchasing power with a lag of one quarter:
[DELTA]w - [DELTA][p.sub.(-1)] = -4,44[DELTA][u.sub.(-1)] (6)
[R.sub.2]=0.12; DW=2,28; t - statistic = -1.85
The last equation estimated in this exercise measures the central bank reaction function for Romania, according to the generic form (4). The estimated equation (7) shows that, next to the monetary base, the exchange rate was an intermediate target of the monetary policy:
[DELTA]e 0,96(Ap - Apext)[DELTA]e (7)
[R.sub.2]=0.51; DW=1,71; t - statistic=9,59
The estimated equations (5), (6) and (7) can be combined in an equation similar to a Philips curve. Thus, by substituting equations (6) and (7) in equation (5) it results:
[DELTA]p = 0,94[DELTA][p.sub.-1] - 0,94 [DELTA]q + 0,06 [DELTA]pext (8)
Equation (8) shows the importance of the inertial component in the inflation process. This component demonstrates the significant role of inflation expectations in the Romanian economy. In order to illustrate the importance of the inertial component, let's suppose that we start from an inflation of 40% and we want to reach an inflation of 10% provided that, in equation (8), labor productivity, unemployment and foreign prices do not change. In this case, the only inflation factor remains inertia, reflected by Ap< -1). With the above assumptions, we have the following relation:
10% = [(0,94).sup.m] x 40% (9)
from which we obtain m = 22.4 years. Therefore, calculations show that 22.4 years would be needed to achieve disinflation from 40% to 10% annually.
There is another implication of the above hypothetical calculation: labor productivity growth compensates some of the inflationary inertia in the conditions when the wages recover purchasing power, according to the equation (7). U (U is zero), then the wages fully recover the purchasing power with a lag of one quarter:
[DELTA]w - [[DELTA]p.sub.(-1)] = [-4,44Au.sub.(-1)] (10)
[R.sup.2]=0,12; DW=2,28; t-statistic=-1,85
The last equation estimated in this exercise measures reaction function of the central bank for Romania, according to the generic form (4). The estimated equation (10) shows that, together with the monetary base, the exchange rate was an intermediate target of the monetary policy:
[DELTA]e = 0,96([DELTA]p - [DELTA]pext) (11)
[R.sup.2]=0,51; DW=1,71; t-statistic=9,59
The estimated equations (5), (9) and (10) can be combined in an equation similar to a Phillips curve. Thus, by substituting equations (9) and (10) in equation (5) it results:
[DELTA]p = 0,94[[DELTA]p.sub.(-1)]4,44[[DELTA]u.sub.(-1)] - 0,94[DELTA]q + 0,66[DELTA]pext (12)
Equation (12) shows the importance of the inertial component in the inflation process. This component demonstrates the significant role of inflation expectations in the Romanian economy. In order to illustrate the importance of the inertial component, let's suppose that from an inflation of 40% we want to reach an inflation of 10%; under these circumstances, in equation (8), labor productivity, unemployment and foreign prices do not change. In this case, the only inflation factor remains inertia, reflected by Ap< -1). With the above assumptions, we have the following relation:
10% = [(0,94).sup.n] x 40% (13)
from which we obtain n = 22.4 years. Therefore, calculations show that 22.4 years would be needed to achieve disinflation from 40% to 10% annually.
ANALYSIS OF INFLATIONARY FACTORS IN ROMANIA
There is another implication of the above hypothetical calculation: labor productivity growth compensates some of the inflationary inertia in the conditions when the wages recover purchasing power, according to the equation (7).
If the unemployment rate and foreign prices do not change, then equation (8) shows that the objective of price stability requires labor productivity to fully compensate the previous inflation.
An example is enlightening again. Take the case of 2000. If productivity had increased by 54.8% (inflation rate in 2009), and the impact of unemployment and foreign prices would have been zero, then inflation in 2000 would have reached zero. In any case, equation (8) illustrates the general valid conclusion that labor productivity growth supports the inflationary process. Equation (8) shows how strong is the inverse correlation between inflation and unemployment in Romania. Of all factors included in equation (8), the largest coefficient corresponds to the rate of unemployment. This explains why the control of domestic absorption (through monetary, fiscal or revenue policies) was difficult to do or was done to an insufficient extent. For example, in 2007-2009, when the economy was in deep recession, the application of policies, meant to reduce domestic absorption to the necessary extent, perspective of disinflation would have caused unemployment rates well above the actual record.
Table 1 shows the contribution of the factors explained in the equation (8) to the formation of inflation in Romania during 2005-2010?.
Table 1 Factorial analysis table of inflation in Romania during 2005-2010 (percentage contribution factor for inflation, annual average) Inflationary Unemployment Rate Work Inertia Modification Productivity ([[DELTA]p.sub.(-1)]) ([[DELTA]u.sub.(-1)]) Modification ([DELTA]q) 2005 98,6 23,1 -46,8 2006 83,0 35,4 -22,3 2007 93,1 -3,7 2,5 2008 109,4 -20,3 -0,9 2009 88,4 -25,4 -8,6 2010 99,8 7,2 -7,4 External Other Inflation Factors * ([DELTA]pext) 2005 0,7 24,4 2006 0,5 3,4 2007 0,1 7,9 2008 0,3 11,4 2009 0,4 45,2 2010 0,6 -0,2 * Represents the factors, not being explained in the econometric estimation equation, that are accumulated in the estimation errors. For each year, the percentage contribution amount of factors to the inflation rate is 100.
The table shows that the inertia factor has an overwhelming role in the formation of inflation. Immediate implication is that inflation expectations removal, construction and credibility are the most effective policies to reduce inflation. This requires consistency and coherence both in the mix of macroeconomic policies and in the structural reforms. Maladjustments in the mix of policies or the inconsistency in the application of a stabilization program have enormous costs, as shown in the component [DELTA]p(-1)
Significant disinflation has costs in terms of increasing unemployment rate. Modification in the unemployment rate supported disinflation in 2007-2009. (4) Restructuring measures in 2007 and 2008 have resulted in significant adjustments of the labor force, whose positive impact in terms of inflation was also reflected within one year. The table above shows one of the fundamental principles of the economy, namely that, at least on short term, there is a compromise between inflation and unemployment. In other words, if you want a rapid disinflation, there have to be undertaken the costs, in terms of increased unemployment.
Except for the years 2005 and 2006, the contribution of the labor productivity to the disinflation was relatively low. As with unemployment, labor productivity contribution estimates show that the economic restructuring process was not fast enough at least according to the needs of disinflation. The data demonstrate the need to support disinflation by measures that should accelerate restructuring of the real economy, with positive impact on labor productivity.
The relatively low contribution, with the exception of 2009, of other factors that are not explained in equation (8), proves that the econometric estimation was based taking into consideration the most significant factors of inflation. The unexplained factors played a greater role in 2009 because that year there were expectations that Romania could not meet debt service and enter into financial crisis.
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Spiru Haret University
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|Publication:||Economics, Management, and Financial Markets|
|Date:||Dec 1, 2012|
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