1. DETERMINANTS OF INFLATION IN ROMANIA Student: COVRIG NICOLAE Supervisor: Prof. MOISĂ ALTĂR

2. Determinants of Inflation in Romania DOFIN, Bucharest, June 2002 2 The facts... Inflation in CEE transition economies (annual percentage change)

3. Determinants of Inflation in Romania DOFIN, Bucharest, June 2002 3 The goals... To find out the causes of high and persistent inflation in ROMANIA To asses the role of monetary and other economic policies in the disinflation process

4. Determinants of Inflation in Romania DOFIN, Bucharest, June 2002 4 Possible explanations... Supply or cost-push pressures »wages »currency depreciation Demand-pull factors »monetary expansion to finance fiscal deficits »large nonsterilized capital inflows Structural changes or rigidities »price deregulations »relative price changes

5. Determinants of Inflation in Romania DOFIN, Bucharest, June 2002 5 …and answers for Romania case The most important factors in driving inflation are the relative price adjustments and the high volatility of inflation Nominal exchange rate depreciation and the nominal wage increases remain a source of inflationary pressures due to risk of spill-overs The monetary sector of the economy is not an important determinant of inflation There is an important inertia component in the inflation evolution The inflationary expectations can be cut off only through coherent structural policies

6. Determinants of Inflation in Romania DOFIN, Bucharest, June 2002 6 Modelling Approach MONEY MARKETLABOUR MARKET FOREIGN EXCHANGE MARKET Deviation from long-run equilibrium (lagged one period) VAR MODEL Short term dynamics of endogenous variables RELATIVE PRICE ADJUSTMENTS ADMINISTRATIVE DECISIONS ABOUT PRICES Exogenous variables Cointegration analysis (in level of variables) Sample: 1996:01 – 2002:02 Frequency: monthly

7. Determinants of Inflation in Romania DOFIN, Bucharest, June 2002 7 LONG RUN EQUILIBRIUM ON THE MONEY MARKET Theoretical consideration (Ericsson 1998) Where: - nominal money demand (in log) - scale variable, GDP for instance (in log) - rate of return on money itself (expressed in level) - rate of return on assets outside of money (expressed in level) - rate of inflation

8. Determinants of Inflation in Romania DOFIN, Bucharest, June 2002 8 LONG RUN EQUILIBRIUM ON THE MONEY MARKET Choice of variables for Romania case (1/8) Monthly observation for M2XR where M2XR = M2R – resident’s foreign currency deposits M2XR is I(1) Seasonally adjusted time series was use

9. Determinants of Inflation in Romania DOFIN, Bucharest, June 2002 9 LONG RUN EQUILIBRIUM ON THE MONEY MARKET Choice of variables for Romania case (2/8) THE CHOICE OF M2XRSA WAS JUSTIFIED BY: the strong correlation between M1R and M2XR the intention to capture the monetary substitution the greater volatility in M2XR the avoidance of portfolio reallocation due to financial innovation

10. Determinants of Inflation in Romania DOFIN, Bucharest, June 2002 10 LONG RUN EQUILIBRIUM ON THE MONEY MARKET Choice of variables for Romania case (3/8) As scale variable we use the volume of industrial production (seasonally adjusted series) LYSA ~ I(1) at 99% To put in evidence the optimal portfolio selection we use: the nominal deposit rate applied by banks to non-bank customers (% per year) DR ~ I(1) at 99% The nominal depreciation of ROL against USD is used as proxy for return of deposits in foreign currencies as principal assets outside the M2XR DLEXUSD ~ I(0) or I(1) taking into account the structural break

11. Determinants of Inflation in Romania DOFIN, Bucharest, June 2002 11 LONG RUN EQUILIBRIUM ON THE MONEY MARKET Johansen cointegration analysis (4/8) REMARK: DUMMY9703 included – cointegration test possibly affected 2 LAGS IN VAR

12. Determinants of Inflation in Romania DOFIN, Bucharest, June 2002 12 LONG RUN EQUILIBRIUM ON THE MONEY MARKET Johansen cointegration analysis (5/8) LM2XRSAYSADRDLEXUSDIntercept Unrestricted cointegrating coefficients for: -0.289850.373130.0087696-0.00278712.4736 Normalized cointegrating coefficients for: 1.2873 (0.42922) [-2.99916] 0.030255 (0.00430) [-7.03754] -.0096157 (0.00219) [ 4.38687] 8.5340 (0.17448) [-48.9117] Adjustment coefficient for -0.025066 0.0164455.244893-0.95072

13. Determinants of Inflation in Romania DOFIN, Bucharest, June 2002 13 LONG RUN EQUILIBRIUM ON THE MONEY MARKET Johansen cointegration analysis (6/8)

14. Determinants of Inflation in Romania DOFIN, Bucharest, June 2002 14 LONG RUN EQUILIBRIUM ON THE MONEY MARKET Statistics for Johansen cointegration analysis (7/8)

15. Determinants of Inflation in Romania DOFIN, Bucharest, June 2002 15 LONG RUN EQUILIBRIUM ON THE MONEY MARKET Error correction term (8/8) The large disequilibria are strongly related to the nominal exchange rate depreciations and to the nominal deposit rate increase MODELLING APPROACH

16. Determinants of Inflation in Romania DOFIN, Bucharest, June 2002 16 LONG RUN EQUILIBRIUM ON THE LABOUR MARKET Theoretical consideration Real wage W/P is a mark-up over the labour productivity LP where and P – level of price E - employment W – net nominal wage Y - output

17. Determinants of Inflation in Romania DOFIN, Bucharest, June 2002 17 LONG RUN EQUILIBRIUM ON THE LABOUR MARKET Variable evolution ALL VARIABLES ARE I(1)

18. Determinants of Inflation in Romania DOFIN, Bucharest, June 2002 18 LONG RUN EQUILIBRIUM ON THE LABOUR MARKET Johansen cointegration test REMARK: SEASONAL CENTERED DUMMIES WERE INCLUDED DUMMYDEC and DUMMYJAN; 10 LAGS IN VAR

19. Determinants of Inflation in Romania DOFIN, Bucharest, June 2002 19 LONG RUN EQUILIBRIUM ON THE LABOUR MARKET Johansen cointegration test VariableLWAGRLLPLMARKUPTrendIntercept Normalized adjustment coefficient for: -0.76683 0.242304 [-3.16475] -0.21153 0.25253 [-0.83762] 0.287776 0.370434 [ 0.77686] Normalized cointegrating coefficients for: 1.07563 -0.08339 [-12.8994] 0.69167 -0.05966 [-11.5943] -0.002221 -0.00025 [ 9.05362] -0.099123

20. Determinants of Inflation in Romania DOFIN, Bucharest, June 2002 20 LONG RUN EQUILIBRIUM ON THE LABOUR MARKET Additional statistics

21. Determinants of Inflation in Romania DOFIN, Bucharest, June 2002 21 LONG RUN EQUILIBRIUM ON THE LABOUR MARKET Additional statistics

22. Determinants of Inflation in Romania DOFIN, Bucharest, June 2002 22 LONG RUN EQUILIBRIUM ON THE LABOUR MARKET Error correction term (8/8) MODELLING APPROACH

23. Determinants of Inflation in Romania DOFIN, Bucharest, June 2002 23 RELATIVE PRICE ADJUSTMENTS (1/7) Theoretical considerations Ball and Mankiw (1995) offer sound justification for including skewness of the distribution of relative price changes as an explanatory variable for inflation Ball and Mankiw (1994) explain the mechanism through which inflation is influenced by the variance of the shocks Reasons for asymmetric, relative price adjustments - the cost-recovery hypothesis - relative wages of high-skilled workers may be slow to adjust to equilibrium - insufficient adjustment of measured prices for quality improvements - the Balassa-Samuelson effects assymetric shocks are very important trend inflation is very important

24. Determinants of Inflation in Romania DOFIN, Bucharest, June 2002 24 RELATIVE PRICE ADJUSTMENTS (2/7) 35 classes of goods and services in the CPI structure

25. Determinants of Inflation in Romania DOFIN, Bucharest, June 2002 25 RELATIVE PRICE ADJUSTMENTS (3/7)

26. Determinants of Inflation in Romania DOFIN, Bucharest, June 2002 26 RELATIVE PRICE ADJUSTMENTS (4/7) Highest price changes between 1997 and 2002 Smallest price changes between 1997 and 2002

27. Determinants of Inflation in Romania DOFIN, Bucharest, June 2002 27 RELATIVE PRICE ADJUSTMENTS (5/7)

28. Determinants of Inflation in Romania DOFIN, Bucharest, June 2002 28 RELATIVE PRICE ADJUSTMENTS (6/7) High skewned distribution

29. Determinants of Inflation in Romania DOFIN, Bucharest, June 2002 29 RELATIVE PRICE ADJUSTMENTS (7/7) MODELLING APROACH

30. Determinants of Inflation in Romania DOFIN, Bucharest, June 2002 30 ADMINISTRATED PRICES Twelve month percentage change

31. Determinants of Inflation in Romania DOFIN, Bucharest, June 2002 31 ADMINISTRATED PRICES “Net inflation” (1)

32. Determinants of Inflation in Romania DOFIN, Bucharest, June 2002 32 ADMINISTRATED PRICES “Net inflation” (2)

33. Determinants of Inflation in Romania DOFIN, Bucharest, June 2002 33 Autonomous inflation: 27,99 % per annum Inflation inertia: 0.19 ADMINISTRATED PRICES “Net inflation” (3)

34. Determinants of Inflation in Romania DOFIN, Bucharest, June 2002 34 ADMINISTRATED PRICES “Net inflation” (4) MODELLING APPROACH

35. Determinants of Inflation in Romania DOFIN, Bucharest, June 2002 35 SHORT RUN DYNAMICS OF INFLATION (1/7) Unrestricted vector autoregression with one lag and: –Endogenous variables : DLCPI (inflation rate) DLM2XR (the change in real M2XR) DLEXUSDR (real depreciation of ROL against USD) –Exogenous variables: ECTMONEY(-1) (error correction term for real money) ECTWAGE (-2) (error correction term for real wages) WSKEW (weighted skewness of price changes) WSTDEV (weighted standard deviation of price changes) DUMMY9605, DUMMY9612, DUMMY9701, DUMMY9905

36. Determinants of Inflation in Romania DOFIN, Bucharest, June 2002 36 SHORT RUN DYNAMICS OF INFLATION (2/7)

37. Determinants of Inflation in Romania DOFIN, Bucharest, June 2002 37 SHORT RUN DYNAMICS OF INFLATION (3/7)

38. Determinants of Inflation in Romania DOFIN, Bucharest, June 2002 38 SHORT RUN DYNAMICS OF INFLATION (4/7) Impulse response function

39. Determinants of Inflation in Romania DOFIN, Bucharest, June 2002 39 SHORT RUN DYNAMICS OF INFLATION (5/7) Variance decomposition

40. Determinants of Inflation in Romania DOFIN, Bucharest, June 2002 40 SHORT RUN DYNAMICS OF INFLATION (6/7) Parsimonious model

41. Determinants of Inflation in Romania DOFIN, Bucharest, June 2002 41 SHORT RUN DYNAMICS OF INFLATION (7/7) Parsimonious model

42. Determinants of Inflation in Romania DOFIN, Bucharest, June 2002 42 Conclusion and policy implications (1/2) The most important factors in driving inflation are the relative price adjustments and the high volatility of inflation The relative price adjustment process was necessary large shocks induced in the overall price system by energy price changes the persistence of inflation and the relative price adjustment process increase the variability of inflation Nominal exchange rate depreciation generates inflation by: The price of raw material products imported The Balassa-Samuelson effect The nominal wages increases remain a source of inflationary pressures due to risk of spill-overs However, in the next period the real wages evolution will not be an inflationary source

43. Determinants of Inflation in Romania DOFIN, Bucharest, June 2002 43 Conclusion and policy implications (2/2) The monetary sector of the economy is not an important determinant of inflation The monetary policy has been enough tight during the period analysed There is an important inertia component in the inflation evolution The role of inflation expectation The inflationary expectations can be cut off only through coherent structural policies

44. Determinants of Inflation in Romania DOFIN, Bucharest, June 2002 44 The facts... Consumer Price Index (average annual change in %) 19951996199719981999200020001 Romania32.338.8154.859.145.945.734.1 Poland27.819.914.911.87.310.15.5 Hungary28.223.618.314.3109.89.2 Czech Republic 9.18.88.510.72.13.94.7 Slovakia9.95.86.16.710.6126.5 Bulgaria62.11231082.922.30.310.17.4