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Inflation dynamics in new EU member states: the Czech case.

Article Excerpt
Abstract The reduction of inflation to an average EU level is the necessary precondition for any new EU member state to join the Euro area. Inflation in the Czech Republic is analyzed by using both monetarist P-star and the hybrid New Keynesian Phillips curve models. It appears that in the Czech case the P-star model is a somewhat better description of the Czech inflationary process.

Keywords Inlfation-NEW EU member state. Czech Republic. P-star model. Hybrid New Keynesian Phillips Curve Model

JEL Classification E40 050

Introduction

The objective of this paper is to analyze the inflation dynamics in one of the new member states of the European Union--namely the Czech Republic.

The subject of inflation in the new European Union member states is important for two reasons. In general, the price stability (or the lack of it) is very important in facilitating the growth of an economy and promoting the economic compeitiveness (see Fergusson 2005. For a somewhat different case of China, see Gerlach and Peng 2006).

Second, the Czech Republic's future membership in the Euro area demands a low and stable inflation. Hence, it is very important to know which factors affect inflation and how and whether those factors are homemade or imported.

The European Union accession treaties stipulate the mandatory membership in the Euro area for all the new member states. However, the Euro area membership, albeit required, was not automatic on the accession. It is conditioned on the new members' demonstrated ability to comply with the original stipulation of the Stability and Growth pact (SGP) and the exchange rate and inflation stability.

(a) In essence, before joining the Euro, the new member states must:

(b) Bring their inflation levels to a level differing no more than 1.5% point from the average Euro area inflation, as defined by the HCPI index.

(c) Maintain their budget deficits consistently below 3% of GDP.

(d) Maintain the public debt level under 60% of GDP.

(e) Reform and open the domestic financial sector so that it becomes competitive at least within the Euro area.

When these conditions are achieved, a new member state joins the transitory arrangement called ERM II. In this phase not only all the conditions specified above must be observed, but the exchange rate vis a vis Euro cannot fluctuate more than 15% in either direction for at least 2 years. Only then a new member state can become a full fledged EURO state.

Inflation in the New Member States and the Czech Republic

Of the ten states which acceded to the European Union in May 2004, seven (Estonia, Latvia, Lithuania, Poland, Czech Republic, Slovakia, Hungary) have a common background of going through a transformation from the centrally planned economy to market economies until the mid-to late 1990s. Bulgaria and Romania, which joined January 1st 2007, share the same experience.

The most pronounced common features of transformation processes were a deep decline in output and a large increase in inflation, reaching triple digit levels annually in some countries.

In the Czech case, the phenomena of transformation recession and inflation were milder than in most of the other "transformation" countries. Reasons can be traced to both a limited monetary overhang and the proximity of German and Austrian markets which limited the impact of structural shifts in the output area.

The analysis of the Czech economic dynamics in the 1990s and 2000s goes beyond the subject of this paper. However, as far as inflation dynamics and the related economic policies are concerned, two events are important.

First, the policy of the fixed exchange rate used to control inflation in the early to mid 1990s was replaced by the inflation targeting and the floating exchange rate regime in December 1997.

The second major factor affecting the Czech economy and economic policies was the launch of the EU accession process in March-November 1998. This process culminated in May 2004 with the Czech Republic joining the EU as a full-fledged member.

It is therefore reasonable to consider the 1997-1998 period as the major structural and behavioral break for the Czech economy, including the dynamics of the inflation processes.

For these reasons, this paper will analyze the dynamics of inflation in the Czech Republic for the period from 1998 to the end of 2005. This period coincides with the period when the CNB (Czech National Bank) followed the inflation targeting strategy in the environment of a floating exchange rate regime.

However, this choice of the period for the analysis imposes a constraint on the choice of the variables for the empirical approach. There are only 32 quarters between 1998 and the end of 2005 (IQ 2006 was the last period for which data were available at the time of writing. But the GMM approach applied in the NKPC estimate (see below) requires at least one "future" observation, which effectively ends the estimation range in our case at 4Q 2005.)

The relatively short data series then made the application of the most up to date multiequation econometric techniques of the inflation analysis (Gollineli and Orsi 2002; Jansen 2004) unfeasible.

Therefore, the single equation estimation techniques were chosen, namely the P-star model originally developed by Tatom (1990) and the New Keynesian Phillips Curve (NKPC) approach in the form analyzed by Rudd and Whelan (2001, 2005). Those two models are specified in the following part.

Inflation Modeling--P-star and NKPC Models

As theoretical concepts, the P-star and NKPC models reflect different approaches to the modeling and analyzing...