1. Determinants of inflation in Romania ACADEMY OF ECONOMIC STUDIES BUCHAREST DOCTORAL SCHOOL OF FINANCE AND BANKING Supervisor : Prof. MOISĂ ALTĂR Student: FIROIU IULIA BUCHAREST - July 2007-

2. Introduction Monetary inflation - when the supply of money is greater than the level of output (pure monetary theory – Friedman (1969)) Wage inflation - wages increases more than labor productivity, raising the unit labor costs The transmission of import prices in a foreign currency leads to general domestic inflation. I assumed there are three sources of inflation: The objective of the paper is to provide some answers to the question: how has inflation been reduced in Romania and what policies proved to be effective in stabilizing economy.

3. 1.I identified a long-run equation in the monetary and labor sectors; 2.I estimated the inflation equation by incorporating the error correction terms derived from each co integration relationship into the short run model (ECM Model). Money market M2(Y, Dr, RER) Goods market ΔP (ULCt-Pt, RER) VAR model Inflation (ΔP) Real money (M2R) Real Exchange Rate (RER) Labor shares (St=ULCt-Pt) deviations from the long-run equilibrium Monthly data:

4. The Balassa-Samuelson Effect: The productivity grows faster in the tradable sector The wage increases in both sectors The prices of non- tradable goods rise The overall price level in the economy increases I analyzed the impact of the difference in productivity between tradable and non-tradable sectors on inflation. Most of Central Europe’s transition economies have experienced a very rapid productivity growth, especially in the industrial sector. Quarterly data:

5. Melisso Boschi and Alessandro Girardi (2005) - determinants of inflation in the Euro Area economy – find a stable long-run relation connecting the price index, labor shares and import prices. MONEY DEMAND: LITERATURE REVIEW Brada and Kutan (1999) - three transition countries (Czech Republic, Hungary and Poland), -inflation is determined largely by past inflation and by foreign prices; - monetary policy is relatively ineffective Markup Model: De Grauwe and Skudelny (2000) test the Balassa-Samuelson effect for 13 of the 15 EU member countries ( period 1971-1995); - differences in productivity growth between sectors translates into a change in CPI with a coefficient of 0.3. Balassa-Samuelson Effect:

6. Monthly data: realmon_sa = Log (RON M2 / CPI) seasonally adjusted (with Tramo/Seats) ppi_sa = Industrial production index (December 1999=100) seasonally adjusted (with Tramo/Seats) (%) lysa = Log (ppi_sa); seasonally adjusted (with Tramo/Seats) depr = Nominal deposit rate applied by banks to non-governamental non-bank customers (%) e= Nominal exchange rate RON/EUR exch= Log (e) p = Log (HICP Romania_dec97); pf = Log (HICP Eur13_dec97) exchrate ( pf + exch-p) =Real exchage rate RON/ EUR based on HICP. 1. LONG RUN EQUILIBRIUM ON THE MONEY MARKET Md = f(Y ; r; x) Md = money demand in real terms; Y = the level of economic activity, r = the opportunity cost of holding money, and x is a vector of other variables which will be included in the model.

7. Johansen Cointegration Test for the money demand function: No deterministic trend (restricted constant) – 4 lags in the VAR EigenvalueTrace Statistic 5% Critical Value 1% Critical Value None **0.460440107.121653.1260.16 At most 1 **0.33741158.3785434.91 41.07 At most 2 **0.17503625.8621619.9624.60 At most 3 *0.12624310.66132 9.24 12.97 *(**) denotes rejection of the hypothesis at the 5%(1%) level Trace test indicates 3 cointegrating equation(s) at the 1% level realmon_sa = 7.290638+0.651103 * lysa-0.049206 * depr -1.478535 * exchrate The residual: Emm = realmon_sa-7.29 -0.65 * lysa +0.049*depr+ 1.47 * exchrate ~I(0) realmon_sa~I(1) lysa ~ I(1); depr ~ I(1); exchrate~I(1).

8. I tested in VEC - the restriction B(1,1)=1 and B(1,2)=-1 (3 lags in VAR). realmon_sa = 5.620331+lysa-0.034615*depr-1.297562*exchrate The residual: Emmres = realmon_sa - 5.620331- lysa +0.034615*depr+1.297562*exchrate ~ I(0) Actual vs fitted M2 The monetary policy has been rather passive and subordinate to other policy objectives (the exchange rate policy).

9. VariableCoef.Std. Errort-StatisticProb. c 0.036557 0.003279 11.14961 0.0000 DEPR-0.0012490.001134-1.1019440.2739 DLYSA-0.8402210.239528-3.5078110.0008 DEXCHRATE-0.0164900.041299-0.3992670.6908 EMM(-1)-0.0072180.004355-1.6575270.1014 R-squared0.510414 Mean dependent var 0.014026 Adjusted R- squared 0.485307 S.D. dependent var 0.013691 S.E. of regression 0.009822 Akaike info criterion -6.350024 Sum squared resid 0.007525 Schwarz criterion -6.204310 Log likelihood268.5260 F-statistic20.32960 Durbin-Watson stat 1.525251 Prob (F-statistic) 0.000000 Error Correction Equation for the real M2 from the unrestricted VAR:

10. VariableCoefficientStd. Errort-StatisticProb. C0.0348740.00252513.809480.0000 DEPR-0.0014250.001115-1.2781460.2050 DLYSA-0.7032380.246116-2.8573380.0055 DEXCHRAT E -0.0156080.040711-0.3833930.7025 EMMRES (-1) -0.0105710.004709-2.2448800.0276 R-squared0.523928 Mean depend.Var 0.014026 Adjusted R- squared 0.499514 S.D. dependent var 0.013691 S.E. of regression 0.009686 Akaike info criterion -6.378014 Sum squared resid 0.007317 Schwarz criterion -6.232301 Log likelihood 269.6876 F-statistic21.46020 Error Correction Equation for the real M2 from the restricted VAR If there is an excess of money in the present month, in the next month the agents will reduce their money holdings.

11. Stability Tests for the money demand Error-Correction Equation Both specifications are stable in terms of the parameters.

12. Pairwise Granger Causality Tests Null Hypothesis:1 lag Prob 2 lags Prob 3 lags Prob 4 lags Prob 5 lags Prob 6 lags Prob 12 lags Prob LYSA does not Granger Cause REALMON_SA 1.9E- 09 5.9E- 05 0.001 63 0.00 578 0.069 37 0.175 05 0.31 068 EXCHRATE does not Granger Cause REALMON_SA 0.122 67 0.37 732 0.689 28 0.73 686 0.766 87 0.752 80 0.98 586 DEPR does not Granger Cause REALMON_SA 0.000 83 0.09 904 0.022 66 0.05 907 0.028 82 0.084 73 0.00 935 RESULTS: Between the real money M2 (realmoney_sa) and the industrial production (lysa) there is a short term causality relationship. The real exchange rate (exchrate) doesn’t seem to influence the real money M2. There is also a long term relationship between M2 and the deposit rate.

13. 2. The markup model zt=pt – γ * ulct – δ * pmt – η * πt = qt – η * πt (1)  zt= γ*(pt-ulct)+ δ*(pt-pmt)- η*πt (2)  β1*(ulct-pt)+β2*( pmt-pt) + et = πt (3) where zt = retail markup over costs at time t, qt is the “gross markup”, πt= Δpt = inflation rate; γ>=0 and δ>=0 = elasticities of the price level with respect to unit labor costs and import costs; (satisfy the homogeneity restriction γ+ δ=1); η = inflation cost; β1= -γ/η, β2= -δ /η, and et= -zt/η Iprod = Labour productivity index in industry (December 1999 =100); ratio between index of industrial production and index of number of employees; prod = Log (Iprod); st=ulct-p =Labor share = wage-prod-p = realwage - prod Monthly data: CPI = Consumer Price Index (December 1999=100); p = Log (CPI); inflation = p-p(-1)

14. Johansen Co integration Test for the markup model No deterministic trend (restricted constant) – 5 lags in the VAR EigenvalueTrace statistic 5% Critical Value 1 % Critical Value None **0.35254869.86704 34.91 41.07 At most 1 ** 0.330768 36.39436 19.96 24.60 At most 2 0.068566 5.469308 9.24 12.97 *(**) denotes rejection of the hypothesis at the 5%(1%) level Trace test indicates 2 cointegrating equation(s) at both 5% and 1% levels inflation=0.036927*st+0.002914*exchrate+0.211697 inflation~ I(1); st ~ I(1); exchrate~I(1).

15. The equilibrium error term: elab=inflatie-0.036927*st-0.002914*exchrate-0.211697 Normality and stationarity tests for the residual from the markup model

16. Error Correction Equation for inflation: VariableCoef.Std. Errort-StatisticProb. C0.0021400.0027760.7708650.4433 DINFLATIE(-1)-0.1611780.151545-1.0635620.2911 DINFLATIE(-2)-0.1159410.110307-1.0510760.2967 DEXCHRATE-0.0423740.026654-1.5897750.1163 DST-0.0017950.014535-0.1235140.9020 DREALMONSA-0.0205050.062102-0.3301730.7422 ELAB(-1)-0.8028890.190802-4.2079770.0001 EMMRES(-1)-0.0056090.002447-2.2919270.0248 R-squared0.559645 Mean depen. var -0.000492 Adjusted R- squared 0.516833 S.D. dependent var 0.007882 S.E. of regression0.005479 Akaike info criterion -7.481181 Sum squared resid 0.002161 Schwarz criterion -7.242978 Log likelihood307.2472 F-statistic13.07206 Durbin-Watson1.617832 Prob(F-stat)0.000000

17. If wages affect prices, their effect is realized mainly through the magnitude of disequilibrium in the labor sector rather than its unit impact on prices. The speed of adjustment towards the equilibrium is very high (80.28% is absorbed in the next period). This suggests that when the economy is shocked away from the long-run relationship, adjustment back to equilibrium is realized by changes in the rate of inflation through actions of the monetary authorities. The coefficient of the error correction term from the money demand relationship is small indicating that there is little effect of excess money on inflation. This is in line with a finding by Brada and Kutan (1999), who suggested that monetary policy in Poland has been used mainly to support the exchange rate policy.

18. Recursive Residuals Tests for the Error-Correction equation for inflation This figure shows that there is little evidence of regime shifts: variations in the inflation variable are within +/-5% innovation errors.

19. Impulse Response (GIR) functions A shock in the inflation equation implies only a temporary effect on the next evolution of inflation. It takes only two months for the shock to real money to exert a maximum influence on prices, that is 1% The response of prices to real wage shocks shows a cyclical pattern over the first six months, after that the shock is absorbed. The impact response of prices, given a shock to exchange rate, is 1% in the second month and after three months the shock dies out.

20. PeriodS.E.INFLATIONREALMONEXCHRATEST 1 0.005285 100.0000 0.000000 2 0.005645 87.86440 7.145527 4.819774 0.170294 3 0.005658 87.46893 7.116406 4.920808 0.493855 4 0.005701 86.84927 7.093243 4.905791 1.151699 5 0.005770 85.28335 7.902958 4.793715 2.019977 6 0.005820 83.84248 9.066248 5.059694 2.031573 7 0.005831 83.63422 9.035602 5.144102 2.186080 8 0.005849 83.12401 9.277654 5.113768 2.484568 9 0.005864 82.82599 9.409582 5.127039 2.637392 10 0.005870 82.72798 9.393263 5.127278 2.751483 Variance Decomposition of Inflation Real money seems to be the main factor of influence for inflation; the second place is taken by the real exchange rate. The labor share (ulct-pt) has little consequences on variations of inflation.

21. 3. The Balassa – Samuelson Model It is assumed that economies are characterized by two different production functions with constant returns to scale, one for the production of tradable (mainly industrial goods), and one for non-tradable (mainly services). b (1-b) 1.Yt = At * (Lt) + (Kt) c (1-c) 2. Ynt = Ant * (Lnt) + (Kt), where Y = output, A = total factor productivity, L = labour, K = capital, t / nt =tradable / non-tradable good sectors, b and c = labor intensity in the two sectors. First, I will test the relation between unit labor costs and prices in industry: ln Ptrad = ln b + β * ln ULCt + εt, where β is expected to be positive and equal to 1.

22. Quarterly data: CPI = Consumer Price Index (2000:Q1=100) ; p = Log(CPI); inflation = p-p(-1) ; CPItrad =Consumer Price Index in the tradable sector (2000:Q1=100); ptrad = Log(CPItrad); I_prod_trad = Labour productivity index in the tradable sector (2000:Q1=100) = ratio GDP and the number of employees in the tradable sector; prodtrad = Log(I_prod_trad); I_prod_nontrad = Labour productivity index in the tradable sector (2000:Q1=100); ratio between GDP and the number of employees in the nontradable sector; prodnontrad = Log(I_prod_nontrad); difprod = prodtrad-prodnontrad; Iulct = Unit labor cost index in the tradable sector (ratio between index of real nominl net wage in industry and index of industrial production); ulct = Log (Iulct) Secondly, I will test the Balassa - Samuelson hypothesis: the total price level should be driven by the productivity differential between the tradable and non tradable goods sectors

23. VAR Lag Order Selection Criteria Endogenous variables ptrad ulct LagLogLLRFPEAICSCHQ 0 33.9431 2 NA 0.000 294 - 2.457 163 - 2.360 386 - 2.42 9295 1 83.7243 3 88.074 45* 8.70E -06* - 5.978 795* - 5.688 465* - 5.89 5190 * 2 85.9889 1 3.6581 74 1.00E -05 - 5.845 301 - 5.361 418 - 5.70 5960 * indicates lag order selected by the criterion inflation ~I(1); ptrad ~ I(1); ulct ~ I(1); difprod ~ I(1). Stability VAR (1)

24. Johansen Cointegration Test - the relationship between prices and unit labour costs in the tradable sector No deterministic trend (restricted constant) – 1 Lag EigenvalueTrace Statistic 5 % Critical Value 1 % Critical Value None ** 0.528436 34.72969 19.96 24.60 At most 1 ** 0.442369 15.18550 9.24 12.97 *(**) denotes rejection of the hypothesis at the 5%(1%) level Trace test indicates 2 cointegrating equation(s) at both 5% and 1% levels ptrad=1.026758*ulct+6.017215 => the difference between net nominal wages and productivity in industry translates fully into the tradable prices.

25. Endogenous variables: INFLATIE DIFPROD LagLogLLRFPEAICSCHQ 074.83339NA 3.33E- 06 -6.93651-6.83703-6.91492 1 87.67558 22.015 1.44E- 06 -7.77862-7.48019-7.71385 2 97.61135 15.140 8.31E- 07 -8.34393-7.84654-8.23599 3 104.6049 9.3247 6.46E- 07 -8.62903-7.93268-8.47791 4 115.390312.326* 3.62E- 07* -9.27527 -8.379*-9.08096 5 120.36284.7356 3.69E- 07 -9.367*-8.27362 -9.130* * indicates lag order selected by the criterion VAR Lag Order Selection Criteria Stability VAR (4)

26. Johansen Cointegration Test - the relationship between the productivity differential and inflation Trend assumption: No deterministic trend (restricted constant) – 4 lags in the VAR Hypothesiz ed No. of CE(s) Eigenvalu e Trace Statistic 5 % Critical Value 1 % Critical Value None **0.498675 25.20869 19.96 24.60 At most 1 * 0.365774 10.01768 9.24 12.97 *(**) denotes rejection of the hypothesis at the 5%(1%) level Trace test indicates 2 cointegrating equation(s) at the 5% level Trace test indicates 1 cointegrating equation(s) at the 1% level inflation=0.15*difprod-0.002341. The stationarity test for the residual

27. Conclusions: There is a long-run stable relationship between M2 and the other three variables: the index of industrial production the deposit interest rate and the real exchange rate I found that there is little effect of excess money on inflation. In Romania, the same as in other transition economies, the monetary policy was mainly subordinated to the exchange rate policy. Co integration techniques and error correction models used to estimate the relationship between markup and inflation dynamics show a relation between prices and marginal costs and that inflation error-corrects towards this equilibrium.

28. According to the Johansen test the production costs influence inflation. That’s why, in order to assure the stability of prices, the fiscal authorities should play an important role in the inflation process. the Error-correction Model (ECM) for inflation revealed that, on the short- term basis, the policy of wages affects inflation in an indirect way through the magnitude of disequilibrium in the labor sector rather than its unit impact on prices. The Co integration Tests of the Balassa - Samuelson hypothesis show that in the industry sector the unit labor costs fully translates into the level of prices and that the productivity growth differential between sectors has a positive effect on inflation. Conclusions: