Inflation Inflation versus price level Inflation versus price level Determinants of Irish inflation: Determinants of Irish inflation: 1. Euro price of foreign goods Foreign prices (in foreign currency) Foreign prices (in foreign currency) Nominal exchange rate Nominal exchange rate 2. Economic slack Aggregate spending relative to potential output Aggregate spending relative to potential output

Euro price of foreign goods Traded goods (Internationally) Traded goods (Internationally) Law of one price (LOOP) Law of one price (LOOP) P i = 1/e × P i * whereP i = domestic price of good i e = nominal exchange rate P i * = foreign price of good i

Purchasing Power Parity (PPP) P = 1/e × P* whereP = domestic price of traded goods e = nominal exchange rate P* = foreign price of traded goods

Economic slack Non-traded goods Non-traded goods e.g. services e.g. services Y P = A K  L (1-  ) If aggregate spending (demand) greater than Y P then rate of inflation increases If aggregate spending (demand) greater than Y P then rate of inflation increases If aggregate spending (demand) less than Y P then rate of inflation decreases If aggregate spending (demand) less than Y P then rate of inflation decreases

Slack in Ireland Ireland’s potential output growth estimated to be between 4-5 percent Ireland’s potential output growth estimated to be between 4-5 percent Depends critically on assumptions about number of immigrants Depends critically on assumptions about number of immigrants Ireland’s level of actual output estimated to be close to potential output level Ireland’s level of actual output estimated to be close to potential output level i.e. close to zero slack i.e. close to zero slack

Labour market slack Non-accelerating inflation rate of unemployment (NAIRU) Non-accelerating inflation rate of unemployment (NAIRU) If actual unemployment rate below NAIRU then wage inflation picks up If actual unemployment rate below NAIRU then wage inflation picks up If actual unemployment rate above NAIRU then wage inflation eases If actual unemployment rate above NAIRU then wage inflation eases

Labour market slack Ireland’s NAIRU estimated at about 4.5 percent Ireland’s NAIRU estimated at about 4.5 percent Ireland actual unemployment rate is about 4.5 percent Ireland actual unemployment rate is about 4.5 percent