Exchange Rate Pass-Through in Acceding Countries: The Role of Exchange Rate Regimes

Transcription

1 The Tenh Dubrovnik Economic Conference Fabrizio Coricelli, Bošjan Jazbec and Igor Masen Exchange Rae Pass-Through in Acceding Counries: The Role of Exchange Rae Regimes Hoel "Grand Villa Argenina", Dubrovnik June 23-26, 2004 Draf version Please do no quoe

2 Exchange Rae Pass-Through in Acceding Counries: he Role of Exchange Rae Regimes Fabrizio Coricelli Universiy of Siena, Cenral European Universiy and CEPR Bošjan Jazbec Universiy of Ljubljana Igor Masen European Universiy Insiue and Universiy of Ljubljana Absrac This paper analyzes he link beween he choice of exchange rae regime and inflaionary performance in counries acceding o he EU. Esimaion of pass-hrough effec of exchange rae changes o CPI inflaion is complemened by I(2) coinegraion analysis of sochasic nominal rends. The resuls allow a clear ranking of counries according o he size of he pass-hrough effec and he imporance of exchange rae shocks o overall inflaionary performance. The size of he pass-hrough effec can be associaed wih he degree of accommodaion in he exchange rae policy. The paper concludes ha an accommodaive exchange rae policy is one of he main sources of inflaionary pressures in accession counries. JEL codes: E42, E52, E58, C32 Keywords: EMU accession, pass-hrough effec, coinegraion analysis, real exchange rae argeing, policy accommodaion The auhors are indebed o Søren Johansen, Anindya Banerjee, Roland Sraub, Robero Peroi and Jerome Sgard for heir discussions and numerous commens. A previous version of his paper has been circulaed as CEPR Working Paper No All remaining errors are solely our responsibiliy.

3 1. Inroducion Following accession o he European Union, candidae counries (CEECs) will evenually adop he euro, as no op-ou clause is allowed for new enrans. Therefore, he main open quesion abou exchange rae policy for new members is he speed of enry ino he Euro zone. The lengh of he ransiion period o he Euro is herefore an imporan policy choice for CEECs. The chosen sraegy crucially depends on he role policy-makers aribue o he exchange rae for macroeconomic performance. In paricular, a key quesion is he capabiliy of affecing he real exchange rae hrough changes in he nominal exchange rae. This, in urn, depends on he impac ha nominal exchange rae flucuaions have on domesic inflaion, in oher words, on he magniude of he pass-hrough effec. In his respec, he aim of he paper is o empirically analyze he role of exchange rae regimes in overall inflaionary performance of a subse of acceding counries: Hungary, he Czech Republic, Poland and Slovenia (CEEC-4 hereafer). The inerplay beween he exchange rae regime and he speed of convergence of inflaion raes beween CEECs and he Euro zone is sudied by esimaing he pass-hrough from exchange rae changes o domesic inflaion in four CEECs. The exchange rae was he main nominal anchor in mos ransiion economies a he beginning of ransiion. To curb inflaion and mainain macroeconomic sabiliy, he Czech Republic, Hungary and Poland inroduced exchange rae-based sabilizaion programs in he early 90 s, while Slovenia followed a combinaion of arges on M3 and ighly managed exchange rae. Over ime, several CEECs have moved owards a more flexible regime (i.e. he Czech Republic, Poland, Hungary and Slovakia). By conras, Slovenia coninued o mainain managed floa, while ohers, he Balic saes and Bulgaria, oped for currency boards. There is a quesion of wheher a move o more flexible exchange rae regimes have helped ransiion economies o carry on independen moneary policy and o more effecively respond o shocks. To answer his quesion i is imporan o disinguish beween cases where higher exchange rae flexibiliy reflecs an exchange rae policy geared a achieving a cerain inflaion arge, and cases where exchange rae policy is accommodaive, i.e. ries o neuralize he effecs of adverse shocks only on he real exchange rae. In he former case, he changes in he nominal exchange rae faciliae adjusmens of he real exchange rae wih an explici goal of sabilizing inflaion and oupu gap (see Woodford, 2003 and Chaper 4). In he laer case, sabilizaion of he real exchange rae is given prioriy. When aking he form of a reacion funcion o perceived disequilibria in he real exchange rae, a sysemaic componen is induced ino he dynamics of he nominal exchange rae. Such a policy is likely o be incorporaed ino he pricing decisions of economic agens. For his reason, a srong correlaion 2

4 beween exchange rae movemens and inflaion raes can be observed in managed floa regimes. Moreover, a showed by Uribe (2003), a real exchange rae rule resuls in indeerminacy, which implies also inabiliy o conrol inflaion. Following his line of reasoning, we esimae he exen of exchange rae pass-hrough in CEEC-4 and find ha regimes wih a more accommodaive sance of exchange rae policy generae higher pass-hrough. Alhough accommodaive exchange rae rules could sabilize he real exchange rae, i is quesionable wheher such a policy is welfare improving as i generaes coss associaed wih higher average inflaion. Wih exchange rae pass-hrough we denoe a change in he seleced price index caused by he change in he nominal exchange rae. 1 Is empirical imporance has been analyzed in a number of papers in recen years. Campa and Goldberg (2001) esimae pass-hrough o impor prices for 25 OECD counries over he period 1975 o Goldfajn and Werlang (2000) sudy he relaionship beween exchange rae depreciaions and inflaion for 71 counries in he period 1980 o Choudhri and Hakura (2001) exend he sudy of Goldfajn and Werlang (2000) and ry o esablish he role of he exchange rae regime in deermining he exen of pass-hrough in 71 counries in he period 1979 o Darvas (2001) provides evidence on pass-hrough for CEEC-4 for he period 1993 o Our sudy differs subsanially from previous lieraure in he esimaion mehodology employed. Using a coinegraed vecor auoregressive model we esimae he pass-hrough from exchange raes o prices and esimae he imporance of shocks o he nominal exchange rae in he movemens of domesic inflaion for he CEEC-4. In addiion, we invoke heoreical resuls from Johansen (2002) o address he issue of idenificaion of pass-hrough effec, which has no been achieved in previous sudies using coinegraion analysis (e.g. Kim, 1998). Thus, we are no he firs o use coinegraion analysis o esimae exchange rae pass-hrough, bu he firs o solve he idenificaion problem wihin his framework. This qualifies our esimaes as he sysem generalizaion of single equaion esimaes of pass-hrough effec. The empirical analysis indicaes ha pass-hrough is highly significan in he four candidae counries examined, alhough imporan differences emerge, which can be associaed wih differences in exchange rae regimes. While Slovenia and Hungary have engaged in relaively ighly managed exchange raes, he Czech Republic and Poland have le heir exchange rae floa more freely, a leas recenly. Addiionally, he Czech Republic and Poland inroduced inflaion arges, which helped 3

5 moneary auhoriies o mainain inflaion a lower levels han in Slovenia and Hungary. In his respec, i is no surprising ha we found a perfec pass-hrough from exchange rae growh o domesic inflaion for Slovenia and Hungary. A much smaller impac is found for he Czech Republic and Poland. Similarly, in Slovenia shocks o he exchange rae play a dominan role in deermining inflaionary pressures. By conras, in Poland auonomous shocks arising from monopolisic behavior in goods markes and wage pressures dominae he inflaion process, wih smaller effecs from exchange rae shocks. Noe ha Slovenia and Poland have followed raher differen exchange rae policies. Even hough i has never been officially declared, Slovenia apparenly argeed he real exchange rae hroughou he period, rying o mainain exernal compeiiveness. Poland, afer he iniial use of he exchange rae as a nominal anchor, has progressively moved oward a more flexible exchange rae, culminaing in he floaing regime ha sared in April Therefore, one can conjecure ha such differen exchange rae regimes had a fundamenal impac on domesic inflaion. The real exchange rae rule in Slovenia was probably inernalized by price seers, hus becoming a persisen source of inflaion. In fac, alhough Slovenia apparenly had he bes fundamenals of CEEC-4, i is he wors inflaion performer among he Acceding Counries in recen years. By conras, Poland did no follow an accommodaive exchange rae policy. Considering as well ha Slovenia is a much more open and smaller economy han Poland, one would expec a smaller passhrough in Poland and a smaller role of exchange rae shocks driving he domesic inflaionary process. Hungary and he Czech Republic lie beween he wo exreme cases, wih Hungary more similar o Slovenia and he Czech Republic more o Poland. In general i would seem ha more predicable exchange rae policies, like hose followed in Slovenia and Hungary (and Poland unil 2000) end o be associaed wih larger pass-hrough coefficiens. The size and openness of he counries are also imporan facors. The analysis has a number of clear policy implicaions, all based on empirical fac ha exchange rae changes imporanly affec domesic inflaion and hence in any disinflaion experimen he cenral role should be given o he pah of he nominal exchange rae. Even absracing from he issue of propagaion of exogenous shocks originaing in inernaional financial markes, flexible exchange raes are no an effecive insrumen for absorbing asymmeric real shocks (Masen, 2002). Large pass-hrough o impor price is an incenive for policy-makers o aemp ex-pos o drive he exchange rae in a way ha improves exernal compeiiveness. Large pass-hrough o CPI, however, 1 The pass-hrough effec operaes broadly hrough hree basic channels: (1) direc effec hrough prices of impored goods in he CPI; (2) effec hrough prices of impored inermediae goods; and (3) he effec hrough expecaions ha includes also he expeced responses of moneary policy (Garcia and Resrepo, 2001). 4

6 reduces he expendiure swiching effec and benefis of exchange rae flexibiliy. As can be seen in he case of Slovenia, such a policy of real exchange rae argeing creaes persisen inflaionary pressures ha can be broken down by credibly adoping a non-accommodaing exchange rae policy. For a small open economy his may imply he adopion of fixed exchange raes. Luckily, candidae counries have he poin of arrival, he euro, already se. Their main policy decision is how fas o ener he euro. Resuls in his paper sugges ha here are no significan advanages o delaying enry. The paper proceeds as follows. Secion 2 presens sylized facs on inflaion and exchange rae behavior in CEEC-4. Afer briefly discussing he long-run rend appreciaion of he exchange rae and is connecions wih he Balassa-Samuelson effec, he secion emphasizes he relaionship beween exchange rae regime and inflaion dynamics. Secion 3 offers a simple heoreical framework ha links he size of pass-hrough exchange rae regimes and persisence of exchange rae shocks in paricular. Secion 4 conains he main empirical analysis of he paper, focusing on he pass-hrough. Secion 5 concludes. 2. Sylized Facs on Inflaion and Exchange Rae Dynamics Following he iniial jump in price levels associaed wih price liberalizaion, inflaion has declined gradually in CEEC-4. Reducion o single-digi inflaion was much faser in Slovenia and he Czech Republic, counries less affeced by large socks of deb and he aendan need o finance large deb service paymens. However, inflaion raes seem o be more subborn in Slovenia and Hungary han in he Czech Republic and Poland. In he period , inflaion hovered around 8-9 % in Slovenia and Hungary, wih signs of decline afer he second half of 2002, in a period of economic slowdown. The sharp decline in he Czech Republic and Poland reflecs wo differen realiies. The Czech Republic has been successful in reducing inflaion hrough an effecive and credible policy of inflaion argeing. In Poland he fall in inflaion, which declined o around 1% annual rae in 2002, reflecs perhaps an overshooing of he desired decline. This was he resul of an excessively igh moneary policy ha negaively affeced he economy during a period of general economic slowdown in Europe. Oupu performance in Poland during 2002 has been among he wors in candidae counries. A sharp fall in demand and oupu and persisen unemploymen rae a around 18% have conribued o he fall in inflaion. The gradual decline in inflaion has been accompanied by a sizable appreciaion of he real exchange rae in all CEEC-4, and indeed in all ransiion economies. A componen of his rend appreciaion can be considered an equilibrium phenomenon, in line wih he 5

7 Balassa-Samuelson effec and relaive price convergence (on he laer see Čihak and Holub, 2002). However, here is, in addiion, a dynamic process connecing exchange raes and inflaion. Table 1 repors simple correlaion coefficiens beween CPI-inflaion raes, raes of change of nominal exchange raes and raes of change of real exchange raes. Daa refer o 12-monh changes o eliminae seasonal effecs. In Hungary, Poland and Slovenia, he correlaion beween inflaion raes and changes in nominal exchange raes is high. By conras, he correlaion beween inflaion and exchange rae changes is low in he Czech Republic. As a resul, here was a high correlaion beween movemens of nominal and real exchange raes. Ineresingly, Hungary, Poland and Slovenia have kep posiive depreciaion raes on average. While Hungary broke up wih his pracice in second half of 2001 and Poland in Slovenia mainained a posiive depreciaion rae, which is enirely policy induced. I is especially noable for he Czech Republic ha is nominal exchange rae growh never deviaed permanenly from zero, which considerably conribued o is mos favorable inflaionary performance in he CEEC-4 group. Furhermore, he wo counries ha used more acively he exchange rae as a policy ool, Hungary and Slovenia, displayed he smaller volailiy in he real exchange rae, suggesing he presence of some form of real exchange rae argeing. Table 1: Exchange raes and inflaion, 1994:1-2002:5 (*) Czech Republic Hungary Poland Slovenia Correlaion beween changes in nominal exchange rae and inflaion(**) Mean -Nominal exchange rae Real exchange rae Consumer prices Sandard Deviaion -Nominal exchange rae Real exchange rae Consumer prices (*) 12-monh percenage changes (**) Correlaion coefficien beween 3-monh moving average of 12-monh changes Source: Auhors calculaions on daa from Daasream. I is worh sressing ha official changes in he exchange rae regimes need no be fully informaive abou he effec of exchange rae policy on inflaion. As shown in he empirical par of he paper, models for hese counries do no exhibi signs of srucural parameer breaks even hough hree ou of four counries inroduced official changes in heir exchange rae regimes. The degree of 2 Poland adoped a flexible exchange rae sysem wih inflaion argeing in 2000, while Hungary swiched o an inflaion argeing regime in Ocober

8 moneary policy accommodaion can be revealed only by looking closely a acual pah of he exchange rae and resuls of empirical analysis. For Slovenia i is clear ha igh managemen was oriened owards susaining a depreciaion rae, which can be undersood as a sign of accommodaive moneary policy. In he Czech Republic his has no been he case even afer he move o a more flexible arrangemen. Thus even hough wo counries could be officially characerized as having a similar exchange rae regime, i is imporan o ake ino accoun wheher exchange rae managemen is used as a key ool for achieving a prese inflaion arge, or o accommodae any shock o he real exchange rae. While in he former exchange rae does no add o inflaionary pressures, i does so in he laer. 3. Real Exchange Rae Targeing and he Size of Pass-Through Effec Consider a small open economy wih a coninuum of monopolisically compeiive firms ha se heir prices in a saggered manner as in Calvo (1983). Each firm reses is price in any period wih fixed probabiliy1 θ, independenly of oher firms price decisions and memoryless. By he law of large numbers, a fracion 1 θ of firms reses heir prices every period, while a fracion θ keeps heir prices unchanged. Le p denoe he log of he aggregae price level, and p* he log of opimal price level of firms ha receive a price-change-signal in period. This implies ha he curren price level is described by he following law of moion (in log-linear form) p 1 1 * ( θ) p = θ p + The firms maximize he expeced discouned value of profis for given demand schedule, echnology (common across firms), facor prices and he resricion on price adjusmen. Loglinearizaion of he firm s firs-order condiions around a zero-inflaion seady sae yields he following expression for opimal price level (see also Gali, 2001) (3.1) cos. E ( 1 ) ( ) * p = µ + βθ βθ k = 0 k E mc + k (3.2) where µ is he log of he opimal fricionless mark-up and mc he log of nominal marginal () is he raional expecaions operaor. Le us assume ha nominal marginal coss are indexed o a linear combinaion of domesic prices and impor prices where ( γ ) mc = 1 p + γ( e + p f ) (3.3) γ is he share of impored inpus in domesic producion, e is he log of nominal exchange rae and f p is he log of impor prices denominaed in foreign currency. We assume perfec 7

9 exchange rae pass-hrough o impor prices. For simpliciy and wihou loss of generaliy assume ha f p = 0. Moneary policy follows a real exchange rae argeing rule, which is formulaed as in Uribe (2003) f e = g( e + p p ), g() <0 (3.4) This formualion posulaes ha nominal depreciaion increases in response o real apreciaion. I also implies ha ransiory shocks o he real exchange rae combined wih moneary policy rule induce a uni roo in he level of (he log of) nominal exchange rae. Consider a shock o he real exchange rae a ime and no shocks aferwards. This induces a permanen shock o he nominal * exchange rae: e+ k= e; k. I also implies ha p * + k= p; k along he perfec foresigh pah. By solving (3.1) forward and insering ino (3.3) we obain he following expression for he nominal marginal coss * ( 1 γ ) mc = p + γe Insering (3.3) ino (3.2) yields he expression for opimal price level in he case of real exchange rae argeing afer a ransiory shock o he real exchange rae * ( ) * k 1 ( 1 ) ( ) + k k = 0 (3.5) 1 p = µ + γ p + βθ βθ Ee = µ + e (3.6) γ From (3.6) i follows ha permanen shocks o he nominal exchange rae are associaed wih perfec pass-hrough o he opimal price level and by (3.1) also o he CPI in equilibrium. Albei in a less general framework Taylor (2000) showed ha persisence of shocks is a key deerminan of he size of he pass-hrough. I has been shown above ha shocks o he nominal exchange rae are perceived as permanen when agens incorporae a real exchange rae argeing policy ino heir pricing behavior. Again from (3.1) i follows ha in such a case no only will equilibrium pass-hrough be perfec, bu also ha shor-run pass-hrough will be higher. As discussed in he previous secion, exchange rae policy in CEECs can o a grea exen be characerized by elemens of real exchange rae argeing (see also Laxon and Peseni, 2003). Unlike in developed counries for which his pracice canno be confirmed, we would expec o find esimaes of high pass-hrough. The exen o which CEECs have resored o real exchange rae argeing has also differed subsanially across counries. In hose where i has been mos sysemaic (Hungary and Slovenia) finding esimaes of perfec equilibrium pass-hrough should no be surprising. 8

10 4. Esimaion of Exchange Rae Pass-Through This secion presens he empirical analysis of pass-hrough effec of exchange rae growh o CPI inflaion wihin a coinegraion framework. Compared o exising sudies of pass-hrough our empirical analysis inroduces a number of novelies. Firs, wihin I(1) coinegraion analysis he paper offers a formal discussion of idenificaion of pass-hrough effec condiional on coinegraion rank. We show ha repored esimaes of equilibrium pass-hough effec are acually idenified and can hus be inerpreed as elasiciies in a srucural sense. The issue of idenificaion of pass-hrough effec has no ye been addressed in he exising lieraure and as is urns ou his is of crucial imporance when conclusions from empirical analysis are used for policy implicaions. Second, we discussed he necessary conemporaneous correlaion of reduced form shocks ha yields he empirically observed equilibrium pass-hrough effec. Finally, in order o provide beer grounds for proposed policy implicaions, he analysis of common nominal I(2) rends is performed using I(2) coinegraion analysis. The I(2) framework offers, firs, useful ools for direc analysis of relaive imporance of shocks o differen variables for overall inflaionary performance in he economy, and, second, disinguish beween nominal and real rends in he economy. All hese feaures, combined wih acual esimaes, lead o imporan implicaions for he choice of exchange rae regime Mehodological Issues and Limiaions of Exising Empirical Sudies The measure of pass-hrough esimaed in he paper is he effec of changes in nominal exchange raes on CPI inflaion, a common final arge variable of moneary auhoriies. In paricular, he main focus of he paper is he equilibrium effecs of exchange rae changes on inflaion, real ineres raes and oupu. In he lieraure here is no uniform approach o he analysis of pass-hrough. Some auhors aemp o measure he pass-hrough direcly; ohers use empirical resuls o invesigae he underlying economic mechanisms (e.g. Choudhri, Faruqee and Hakura, 2002). In erms of mehodology, srucural VAR is he mos common in he lieraure, of which McCarhy (2000) is a very noable example. In ha approach, pass-hrough is measured by means of impulse responses of differen price series o an idenified srucural exchange rae shock. The problem wih his approach is ha i is no enirely consisen wih he simples noion of pass-hrough: differen ypes of fundamenal shocks can cause co-movemens beween he exchange rae and prices ha are no necessarily he same (Corsei and Dedola, 2003). In principle his implies ha we can observe as many measures of (shor-run) pass-hrough as here are idenified srucural shocks. I also follows from he work of Corsei and Dedola (2003) ha conclusions abou he size of pass-hrough measured 9

11 only as a response o and idenified srucural exchange rae shock should be inerpreed wih cauion. In addiion, exchange rae changes need no occur only as consequences of sochasic shocks, bu hey can also reflec sysemaic changes in policy, ha can be paricularly imporan in counries adoping some form of real exchange rae argeing. I could occur also as he change in he inflaion arge of a cenral bank running disinflaion policies. All such changes are no accouned for in a ypical SVAR analysis. Proposed esimaes of exchange rae pass-hrough could in such a case be severely biased and, no surprisingly, underesimaed (see secion 4.3 for a furher discussion). This problem does no arise in Campa and Goldberg (2002) who esimae a simple singleequaion model for OECD counries and measure he pass-hrough effec (o impor prices in heir case) wih he coefficien on he nominal exchange rae. Single equaion approach is used also by Darvas (2001) for he group of Acceding Counries. A differen use of SVAR analysis is found in Choudhri, Faruqee, and Hakura (2002). Their empirically observed impulse responses of various price indexes o an exchange rae shock are used no o measure pass-hrough effec direcly bu as a benchmark for simulaed responses obained from calibraed heoreical model under differen assumpion abou nominal rigidiies in he economy. A common drawback of all SVAR-based sudies is ha hey do no accoun explicily for he possibiliy of coinegraion. Price series are commonly inegraed a leas of order one, which calls for an explici es for coinegraion. From an economic poin of view, neglecing coinegraion is very surprising since long-run co-movemen of prices and exchange rae seems very plausible heoreically. Neglecing coinegraion when i is genuinely presen means neglecing he inrinsic meaning of equilibrium long-run relaionship beween he nominal exchange rae and prices. In order o mainain comparabiliy wih ypical SVAR-based sudies his paper a he end of he analysis esimaes also a srucural vecor error-correcion (VEC) model (see Warne, 1993 for a deailed discussion). Our analysis improves over exising sudies of pass-hrough in hree ways. Firs, he analysis is conduced wihin he framework of coinegraed vecor auoregression model (CVAR). CVAR has been used in previous sudies (Kim, 1998; Billmeier and Bonao, 2002). As shown below, however, he esimaes of he pass-hrough presened in hese wo sudies are no idenified. Second, he pass-hrough effec is esimaed wihou relying on he idenificaion of srucural shocks. These can be idenified using non-esable resricions, which are very ofen imposed arbirarily and in high-dimensional sysems even wih weak heoreical jusificaions. We use insead he heoreical framework of Johansen (2002) o deermine required conemporaneous changes in endogenous variables conemporaneous pass-hrough effec ha yield equilibrium (long-run) 10

12 responses. In oher words, coinegraion analysis effecively gives informaion on he conemporaneous correlaion beween variables ha suppors a permanen effec on variables of ineres. This correlaion is no esimaed by imposing non-esable resricions on reduced-form parameer space of a VAR, bu is obained direcly from parameers of coinegraed VAR wihou imposing any addiional resricions apar from hose required for idenificaion of he coinegraing vecors. Moreover, he procedure used in he paper direcly disinguishes beween permanen and ransiory shocks. For he analysis of pass-hrough his is a very imporan disincion, since, as shown in Secion 3, only permanen exchange rae shocks can have a non-zero equilibrium pass-hrough effec and hence cause a differen change in pricing behavior of economic agens. I is unlikely ha ransiory exchange rae shocks induce significan shor-run changes in pricing behavior if firms face coss associaed wih frequen price changes. If he analysis is o be used for policy implicaions abou disinflaion policies and he choice of exchange rae regime, racing he effecs of permanen shocks separaely becomes even more imporan. The hird poenial deficiency of exising sudies is ha in general hey do no address he possibiliy of prices, he nominal exchange rae and nominal wages being inegraed of order 2, which is an increasingly common finding in he lieraure (see Banerjee, Cockerell, and Russel (2001); Juselius (1999, 2001); Coenen and Vega (2001); and Ericsson, Hendry, and Preswich (1998)). Also Kongsed (2002), for example, analyzes pricing-o-marke behavior explicily wihin an I(2) coinegraion framework. I(2)-ness of prices effecively means ha inflaion rae is no saionary, i.e. i is driven by a sochasic rend. As a consequence, nominal shocks have a persisen effec on he level of inflaion. Treaing inflaion as saionary resuls in invalid saisical inference. 3 Thus, all resuls obained wihou esing for I(2)-ness in he price level should be inerpreed wih cauion. We find ha prices (as well as nominal wages and he nominal exchange rae) also in he presen sample of counries CEEC-4, can be beer described as variables inegraed of order wo. This is an imporan saisical resul ha allows us o disinguish (wihin he coinegraion framework) beween ransiory and permanen flucuaions in he growh rae (!) of he exchange rae. Adjusmens o fundamenal shocks require only a ransiory change in he growh of nominal exchange rae an adjusmen of he level of he exchange rae o he new equilibrium level. This is also he siuaion where one needs o know he rue naure of he fundamenal shock o make reliable inference abou he size of passhrough (as emphasized by Corsei and Dedola, 2003). Permanen changes in he growh rae of he 3 Economeric invesigaion of he pass-hrough effec on quarerly daa in accession counries is seriously hindered by shor ime series. Namely, he inclusion of a number of conrol variables ha are imporan for 11

13 exchange rae, however, reflec changes ha go beyond relaive price adjusmens. They can be foremos associaed wih he ype of policy (accommodaive) followed and hus i should no be surprising ha pass hrough perfecly ino inflaion. In he empirical analysis we concenrae on such flucuaions permanen changes in he growh of he nominal exchange rae, which enables us o link such a measure of pass-hrough o he ype of exchange rae regime. 4.2 I(2) Analysis of Nominal Sochasic Trends The aim of he I(2) analysis is no o direcly esimae he pass-hrough effec, which is done in I(1) framework, bu o analyze he sources of nominal sochasic rends. Deailed seps of esing and esimaion are repored in Coricelli, Jazbec and Masen (2003). Here we presen only he final resuls. We consider a sysem of domesic nominal variables, o which he index of indusrial producion has been added in order o explore a poenial presence of I(2) rends also in his variable (all variables are in logs): X = ( y, e, cpi, ppi, w ) = 1993:1,...,2002 :5, (4.1) where y denoes he index of oal indusrial producion, e he nominal exchange rae (unis of domesic currency per Euro), cpi he consumer price index, ppi he producer price index, and w average nominal wages. 4 Table 2 conains esimaes of marices α and of he I(2) coinegraion model ha describe he second order sochasic rends (see Johansen, 1995 for echnical deails of noaion, here we concenrae on economic inerpreaion). α marix conains he coefficiens (or weighs) ha 2 shocks o each equaion of sysem (4.1) have in he I(2) rend. We can wrie his as α ε, where ε is he vecor of reduced-form residuals. β measures he corresponding loading coefficiens. The I(2) rend dominaes he long-run sochasic behavior of he economy. If i urns ou ha his rend is nominal, we can conclude ha i deermines he predominan inflaionary pressures in he economy. For each of he four counries we idenify one sochasic I(2) rend and we are ineresed in he relaive imporance of innovaions o differen variables in his rend. I is of paricular ineres o see 2 β 2 2 s 2 s 1 = i = 1 i exchange rae deerminaion quickly leads o a dimension of he sysem ha does no allow for a fully-fledged coinegraion analysis. This daa inensive echnique employed here requires he use of monhly daa. 4 Wages in manufacuring secor only for he Czech Republic. 12

14 (from α 2 vecor) wheher shocks o he nominal exchange rae equaion mos srongly conribue o he rend or wheher his rend is equally or more srongly affeced by shocks o he CPI, PPI or o nominal wage equaion. In he firs case his would imply ha mos of he inflaionary pressures come via he exchange rae, due o he pass-hrough effec. In he second case mos of he inflaionary pressures would come from he pricing behavior of firms. In paricular, a higher weigh of CPI han PPI poins in he direcion of monopoly pricing behavior in he non-radable and service secor. And finally, a high share of nominal wages would imply ha imporan inflaionary pressures come from aggressive rade unions. Of paricular ineres is also he β 2 vecor. I gives he proporions hrough which he I(2) rend feeds ino individual variables, hus indicaing which variable is mos adequaely described as an I(2) variable or an I(1) variable. Wih his we explore wheher he index of indusrial producion is also an I(2) variable and wheher he I(2) sochasic rend is predominaely a nominal one. The I(2) model is esimaed wih he 2-sep procedure proposed by Johansen (1995b). When saisically suppored (see es saisics below Table 2), α and β marices obained in he firs sep ener he second sep resriced. 5 One common feaure of he resuls is ha shocks o oupu and nominal wages equaions do no conribue o he I(2) sochasic rend, which can hus be assumed o be deermined only by he shock o he hree remaining variables: he nominal exchange rae, CPI and PPI. This qualifies he I(2) rend as nominal for every counry. The share of shocks o nominal exchange rae equaion in he nominal sochasic rend is he highes in Slovenia, approximaely wice as large as he corresponding shares of he CPI and PPI shocks, which are roughly equal. This implies ha overall price inflaion in Slovenia is mos srongly affeced by shocks o he nominal exchange rae, and much less from he auonomous pricing behavior of imperfecly compeiive firms. Table 2: Second Order Sochasic Trends and Corresponding Loadings Coefficiens y e cpi ppi w The Czech Republic a α β Hungary b α Noe ha a row of zeros in he α marix in I(2) conex does no necessarily imply ha he corresponding variable is weakly exogenous an hus does no necessarily represen one of he common rends in he model. Two addiional condiion for weak exogeneiy in I(2) sysems have o be esed (Paruolo and Rahbek (1999)). 13

15 β Poland α β Slovenia d α β a Firs wo elemens of α vecor resriced o 0, b Firs and he las elemen of α vecor resriced o 0, χ 2 (2) = 0.28 p-val.=0.87. χ 2 (2) = 1.48 p-val.=0.48. c Firs and he las elemen of α marix, and hird elemen of β resriced o 0, χ (3) = p- val.=0.93. d Second row of α marix and fourh row of β marix resriced o zero, and linear homogeneiy of he CPI index and nominal wages imposed, χ 2 (5) = p-val.=0.07. Exacly opposie is he case of Poland, where he share of he nominal exchange rae is almos negligible, whereas he I(2) rend can be aribued o shocks o he CPI and PPI in roughly equal proporions. For he Czech Republic all hree variables seem o conribue o inflaionary movemens in he economy; however, he share of he nominal exchange rae is considerably smaller han he shares of wo price indexes. From he wo, he share of PPI is higher. For Hungary he siuaion is differen in he sense ha shocks o he PPI conribue lile o inflaion, which is mosly affeced by shocks o he exchange rae, and more imporanly, by shocks o he CPI. As one of he major differences from he PPI and he CPI is ha he laer also reflec prices of non-radable goods, we could infer ha in Hungary an imporan share of inflaionary pressures comes from he non-radable secor. This could arise from a combinaion of monopolisic pricing, wage pressure and adminisraive price changes in non-radable secors. 2 Examinaion of he β 2 vecors, measuring he loadings o second order sochasic rends, can idenify candidae I(2) variables in our sysem. A common feaure of Table 2 is ha he loading coefficien of he I(2) rend ino oupu is considerably smaller han oher coefficiens. This qualifies he index of indusrial producion as being inegraed of order one in all counries. Based on his finding he IIP eners in levels o models in he nex secion, where we consider I(1) sysems. The second common feaure is ha nominal wages (wih he excepion of Hungary) respond very srongly o driving I(2) rend. This implies ha nominal wages adjus srongly o price developmens in order o achieve dynamic adjusmen of equilibrium real wages. 14

16 To summarize, in his secion we have esablished ha prices can be beer reaed as variables inegraed of order 2. In oher words, inflaion rae resuls o be nonsaionary in all four counries. I(1) analysis should herefore operae direcly wih inflaion raes as here is, in addiion, no oher economically meaningful ransformaion suppored by I(2) analysis. The same line of reasoning also holds for he nominal exchange rae, which again resuled o be an I(2) variable. The second imporan finding of I(2) analysis is he idenificaion of he relaive imporance of shocks o differen variables in I(2) rends. A cenral quesion of his paper is how differen exchange rae regimes influence he overall inflaionary performance of an economy. Our priors were ha a regime ha sysemaically depreciaes he domesic currency leads firms o incorporae expeced depreciaions ino heir pricing behavior. Compared wih a regime ha on average mainains he level of he exchange rae sable he nominal exchange rae in such a regime could be less volaile (around a rend); however, a given change, more likely perceived o be permanen, would feed ino prices more srongly and faser. As a resul, exchange rae policy becomes an imporan source of inflaionary pressures and leads o an average inflaion rae considerably above he one corresponding o he srucural dynamics of he economy. In his respec he share of exchange rae shocks in he nominal sochasic rend is he highes (and moreover dominan) in Slovenia, followed by Hungary, he Czech Republic and Poland Esimaing Pass-Through Effec in I(1) Framework In his secion we analyze he following I(1) sysem: 7 * * * X = ( y, e, π π, i i ), (4.2) where y, as before, denoes index of oal indusrial producion, e he growh of nominal exchange * rae, π π he inflaion differenial wih respec o Germany, and i i he nominal ineres rae differenial wih respec o Fibor/Euribor (3 monh). Transformaions of variables (levels or differences) follow from I(2) analysis. Domesic and foreign CPI inflaion rae ener as a homogeneous relaion because he relaion beween nominal exchange rae growh and inflaion differenial is wha we are primarily ineresed in. The coefficien o he inflaion rae differenial can 6 The resuls for he laer counry should be aken wih some reservaion, however, as is VAR model was no saisically compleely saisfacory and he consequences of excess kurosis in I(2) coinegraion analysis are heoreically no ye explored. 7 We do no use a direc reducion from a I(2) o I(1) model, because formal esing revealed ha i would no yield a nominal o real reducion ha would enable idenificaion of pass-hrough coefficien in line wih Proposiion 1 (see below). Insead, I(2) analysis deermined our choice of variables in I(1) models and, more 15

17 be direcly relaed o he pass-hrough effec of nominal exchange rae changes o domesic inflaion. In addiion imposing homogeneiy resricion reduces he dimension of he sysem, which enables a valid saisical inference wih he daa sample available for CEECs. This was also he reason o include he nominal ineres raes as a spread. Producer price inflaion is no included because he equilibrium pass-hrough effec canno be idenified in such a case (see corollary o Proposiion 1 below). The inclusion of indusrial producion permis o conrol for he cyclical posiion of he economy. Wihou such conrols he esimae of pass-hrough in an economy facing real appreciaion will necessarily be larger han uniy, ha is also wha Campa and Goldberg (2002) repor for some counries. Bu such a coefficien clearly does no ake ino accoun only he effecs of he nominal exchange rae on he price level and hence canno be inerpreed as he pass-hrough effec. For he same reason he sysem also includes foreign inflaion and ineres rae spread in order o accoun for ineres rae pariy effecs. Exploring coinegraion relaions among he variables of he sysem enables us o esimae he equilibrium pass-hrough effec of (permanen) nominal exchange rae changes ino he spread beween domesic and foreign inflaion. A firs sigh he measure of pass-hrough would seem o be he coefficien beween inflaion differenial and exchange rae growh in a coinegraion relaion ha conains boh hese variables and poenially oher variables of he sysem. However, closer inspecion of admissible long run equilibrium changes in variables combined wih basic economic laws reveals ha he measure of pass-hrough depends on coinegraing rank. Consider an I(1) sysem wrien as k 1 X (4.3) =Π X 1 + Γi X i +Φ D + ε i= 1 wih a corresponding reduced rank condiion Π= αβ (see Johansen, 1995a for a deailed presenaion). The marix β conains he coinegraing relaions and α conains he corresponding loading coefficiens. Marices C and Γ are defined as ( ) 1 C = β α Γβ α and k 1 Γ= I Γ i= 1 i α β where and are he orhogonal complemens o α and β respecively. In he following we invoke resuls in Johansen (2002). From he soluion of he error-correcion model is follows ha he long run value as a funcion of curren values ( X, X,..., ) is given by X / 1 X k+ 1 imporanly, conemplaed he analysis of he size of pass-hrough wih mos imporan sources of nominal 16

18 k 1 = lim (,..., ) = ( Γ X i i ) X E X X X C X / h + h k+ 1 = 1 i. (4.4) The long-run changes in endogenous variables are hus proporional o β. A given long-run change k sp( β ) can be achieved by eiher adding k o all curren values or by adding Γk o X a shor-run change. I is also assumed in wha follows ha coinegraing vecors are idenified using zero resricion, which jusifies he inerpreaions used below (see Proposiion 2 in Johansen (2002)). The following proposiion gives a sufficien and necessary condiion for idenificaion of pass-hrough effec. Proposiion 1 Equilibrium pass-hrough effec is idenified if and only if he coinegraing rank r is equal o 1 plus he number of variables wih non-zero coefficien in k s p( β ). Proof: is a p dimensional vecor of variables. Wihou loss of generaliy assume π π is X placed firs and e second, all oher p-2 variables are below. Consider a long-run change k = ( µ,1, k,0 1 ( x p 2 n)), ha is, a long-run change in depreciaion rae by one percenage poin * accompanied by a long-run change in inflaion differenial by µ percenage poins, while allowing for a non-zero effec on n variables in sub-vecor k. µ measures he equilibrium pass-hough effec and is a parameer ha needs o be uniquely idenified. Noe ha k s p( β ), hence he parameers in k mus solve k β=0. β is rxp and i mus be idenified using zero resricion (see Johansen, 2002). k has n+1 unknown parameers. k β=0 is herefore a sysem of r linear equaions and n+1 unknowns. I has a unique soluion when r=1+n. In such a case µ is uniquely idenified. Unless we have some prior saisically non-esable informaion for parameers of k his is also he only case when i can be idenified. I direcly follows from Proposiion 1 ha idenificaion of pass-hough effec implies also ha a long-run equilibrium change in he depreciaion rae has non-zero equilibrium effec on n=r-1 variables in X. This leads o he following corollary o Proposiion 1. Corollary When pass-hrough effec is idenified in a p-dimensional sysem, permanen exchange rae changes have a non-zero equilibrium effec on r-1 variables oher han inflaion. Economic meaning of Proposiion 1 and is corollary can be seen from he following example. Le s look a he following example how Proposiion 1 can be applied o his case. shocks, which is a crucial elemen in policy analysis. 17

19 * * Example: Le s wrie X = ( π π, e, i i, y). In our four-dimensional sysem coinegraion rank is found o be hree (r=3). In such a case idenified coinegraion relaions can be wrien as * * * π π = λ1 e; π π = λ2( i i ); i i * = λ3y, wih corresponding coinegraing vecors: β = (1, λ, 0, 0), β = (1, 0, λ, 0) and β = (0,0,1, λ ) The orhogonal complemen o hese vecors (normalized on he second elemen) is β ( λ,1, λ, λ λ ), a one-dimensional space. In his case he pass-hrough effec is idenified and = direcly measured by λ 1. Noe ha rank hree implies also ha he long-run relaion beween exchange rae changes and inflaion is suppored by a non-zero effec on real oupu, whereas his is no necessarily he case for lower rank orders. I is also easy o see why pass-hrough effec is no idenified in he case of r=1. The coinegraing vecor in his case is heory (inernaional ineres rae pariy) ells us ha we need o consider a long-run change of he ~ form k = ( µ,1, µ,0) (wihou loss of generaliy assume a zero effec on oupu), where µ is he β 1 β = (1, λ, λ, λ ). Economic measure of pass-hrough. Clearly µ = λ 1 is no he measure of pass-hrough because k = (λ, 1, µ,0 is no orhogonal o. The esimae of pass-hough would hus be µ ~ = + λ µ ; however, wihou a λ1 2 prior knowledge of µ µ is no idenified. Taking µ = 1 arbirarily is valid only if we can assume saionariy of he ineres rae premium, which is empirically no confirmed. We can combine he conclusions from hese examples and he corollary o Proposiion 1 o he following definiion: Definiion 1: Equilibrium pass-hrough effec is measured by he coefficien of nominal exchange rae growh on he difference beween domesic and foreign CPI inflaion in a coinegraing relaionship ha conains no oher variables. 3 1 ) In line wih Proposiion 1 idenificaion of long-run or equilibrium pass-hrough effec depends on coinegraing rank. When idenificaion can be achieved (cases wih r=2 or 3), we can also deermine wha is he corresponding conemporaneous pass-hrough effec a shor-run change ha suppors a given long-run change. As seen above, a given long-run change k sp( β ) can be achieved by adding Γk o X. We can inerpre a change in X by Γk also as he effecs of shocks 18

20 ha clearly have permanen effecs on (some) variables in. In fac, his is a resricion any ype of shock in srucural sense (real and nominal) ha economic heory can jusify o have a permanen change given by k sp( β ). In addiion, shor-run changes Γ k need no occur only due o exogenous shocks ( ε in expression 4.3), bu also as a consequence of sysemaic policy reacions and changes in policy arges. Our focus is on permanen effecs of changes in exchange rae growh on inflaion, because exchange rae shocks ha are only ransiory do no necessarily induce significan changes in pricing behavior of firms Γk conains he conemporaneous effec of a permanen exchange rae change on inflaion and oher variables. This characerizaion of shocks is no based on any non-esable resricion imposed on reduced form parameers of he (coinegraed) VAR. Indeed, any alernaive idenificaion scheme ha can be found in srucural VAR lieraure should be able o replicae his conemporaneous effecs oherwise i would fail o idenify he rue permanen exchange rae shock in srucural sense. All oher shocks (hree in our case) cause only ransiory flucuaions around longrun equilibrium values. This example is also insrucive for how misleading would be he srucural VAR analysis wihou iniially performing he permanen-ransiory decomposiion, which effecively boils down o esing for coinegraion. X 4.4 Resuls of I(1) Analysis Lag lengh of he sysems has been chosen by complemenary use of sandard informaion crieria and he usual Wald-ype ess for a valid lag reducion. I proved sufficien o include wo endogenous lags for Slovenia, hree for Hungary and he Czech Republic and four for Poland. 8 Tess for model misspecificaion are presened in Table A2 in he appendix. Again we can conclude ha final models do no suffer from misspecificaion. There are only some signs of non-normaliy of he residuals for Hungary and Poland, bu again i should be emphasized ha he key assumpion for he validiy and robusness of coinegraion analysis is ha he residuals be sochasically independen and his is foremos confirmed by he absence of residual auocorrelaion. 9 8 As a robusness check also sysems wih 4, 6 and 8 lags have been esimaed. I was encouraging o find ha he choice of rank does no change wih lag lengh. Moreover, lag lengh leaves he esimaes of coinegraing space virually unchanged. The variaion in parameer esimaes is so small ha i does no change he conclusions presened in he paper. 9 The parameer sabiliy of he VARs has been esed wih recursive 1-Sep and Break-Poin Chow ess. The ess reveal no signs of parameer insabiliy for all counries. The same urns ou o be he case for he Hansen- Johansen es of consancy of coinegraion coefficiens. These es are available upon reques. 19

21 The choice of coinegraion rank is 3, uniformly across all four counries. Boh he asympoic and boosrap versions of he race es indicae his very clearly for Slovenia, Hungary and Poland, while rank 2 is also possible for he Czech Republic. We have neverheless chosen rank 3 also for he laer counry as he sysems show significan and srong equilibrium correcion o he hird coinegraing relaion, and because we waned o mainain direc comparabiliy of resuls beween all four counries. Visual inspecion of he esimaed hird coinegraing vecor presened in Figures A1 A4 also show no obvious signs of non-saionariy for all counries and he Czech Republic in paricular. The lef panel of Table 3 presens he esimaes of jus-idenified coinegraing vecors. The righ panel repors he corresponding adjusmen coefficiens. Signs of all coefficiens are consisen wih economic heory. The mos informaive for he analysis of pass-hrough effecs is he second coinegraing vecor β 2 and, in paricular, is firs coefficien. As explained in previous secion, i can be inerpreed as long run or equilibrium pass-hrough effec. We can observe ha i is he larges in Slovenia and pracically idenical o 1. For Hungary i is only marginally differen, and for boh counries he resricion ha i is acually equal o 1 canno be rejeced, (see he corresponding likelihood raio ess repored under Table 2) wih corresponding p-values above For Poland he poin esimae of his coefficien is 0.86; however, we sill canno say ha i is saisically significanly differen from 1. The corresponding es has a p-value of The smalles is he poin esimae of he coefficien for he Czech Republic, below 0.5. However, if we impose weak exogeneiy of he indusrial producion index (saisically suppored) and hen es joinly he hypohesis ha he pass-hrough coefficien is equal o 0.5, we canno rejec he resricions (corresponding p-value is 0.09). 2 χ Table 3: Esimaed Coinegraing Relaions and Loading Coefficiens β 1 β 2 β 3 α 1 α 2 α 3 The Czech Republic a (1993: :7) y e (0.06) π π * (0.19) i-i* 0.03 (0.001) Hungary b (1993:2 2002:7) y e (0.10) π π * (0.11) i-i* 0.03 (0.004)

22 Poland c (1993:1 2002:4) y e (0.10) π π * (0.08) i-i* 0.03 (0.006) Slovenia d (1993:3 2002:3) y e (0.10) π π * (0.20) i-i* 0.01 (0.001) Bold indicaes significance. Sandard errors in parenheses. a 2 2 H 0 : β = ; χ () 1 = 2. 52, p-val.=0.11. Weak exogeneiy of y: χ () 3 = 3. 03, p-val.=0.39. Weak () 9 exogeneiy of i-i*: χ 3 =. 42, p-val.=0.02. Weak exogeneiy of y + H0: β 21 = 0.5 ; χ ( 4) = 8. 07, p-val.=0.09. b 2 H 0 : β = ; χ () 1 = 0. 01, p-val.= c H 0 : β = ; χ () 1 = 0. 24, p-val.=0.61, H0: β = ; χ () 1 = 0. 76, p-val.= d H 0 : β = ; χ () 1 = 0. 00, p-val.= To complee he exposiion of I(1) analysis i is also imporan o look a he corresponding α coefficiens in Table 3, measuring he adjusmen o he long-run relaions. The mos imporan finding is ha oupu does no respond o deviaions from he second and hird coinegraing relaions, which represen open-economy pariy relaions. This srenghens he inerpreaion of coefficien as he measure of pass-hrough effec. I implies ha afer an exchange rae shock o his relaion, oupu almos does no adjus in equilibrium. In he inerpreaion of coefficien his allows us o absrac from oupu movemens ha cause rend movemens in he real exchange rae, namely real appreciaion. I is surprising a firs sigh ha only he exchange rae adjuss srongly and significanly o he second coinegraing relaion. One would expec his also for he inflaion rae differenial. However, corollary o Proposiion 1 (see also he lef panel of Table 4 below) implies ha any permanen increase in exchange rae depreciaion ha also increases inflaion mus be mached wih a corresponding increase in he ineres rae spread. We can observe from he vecor of adjusmen coefficiens o he hird coinegraing relaion α a very srong equilibrium adjusmen of inflaion 3 (posiively in response o a posiive exchange rae shock ha increases he ineres rae spread). Therefore, shocks o he second coinegraing relaion alone canno be inerpreed as exchange rae changes induced by moneary policy because hey are no mached by a conemporaneous increase in ineres rae spread and hence canno be expeced o have an effec on inflaion per se. β 21 β 21 21