Inflation in New EU Member States: A Domestically or Externally Driven Phenomenon?

Abstract

This paper analyzes the domestic and external inflation determinants for eight non-eurozone new EU member states (NMS). The empirical literature has been rather silent on the comparison of the relative importance of domestic vs. foreign inflation determinants. This paper aims to fill this gap and add to the literature by several methodological and empirical contributions. Empirical analysis is based on the structural vector autoregression (SVAR) model. It enables the authors to decompose inflation into its domestic and foreign component via historical decomposition analysis. Results indicate that foreign shocks are a major factor in explaining inflation dynamics in the medium run, while the short run inflation dynamics is mainly influenced by domestic shocks. Moreover, the importance of the foreign inflation component has had a rising trend in the pre-crisis period in all NMS, while the start of that trend mostly coincided with their accession to the EU. The global financial crisis seems to have decreased the importance of the foreign inflation component, although the results vary across countries. Since foreign shocks proved to be a very important determinant of inflation in NMS, the main policy implication of this study is the need to augment the classical Taylor rule with foreign factors in case of small open economies.

Global or Domestic? Which Shocks Drive Inflation in European Small Open Economies?

“…According to these estimates nearly 50% of the variation in the price level can be explained by external shocks. Globan et al (2015) in the research on the non-eurozone new EU member states inflation, divide inflation determinants into domestic and global ones. The results, in general, indicate that the short-run inflation dynamic is mainly explained by the domestic factors whereas in the medium-run foreign shocks become a major drivers of inflation in these countries.…”

“…In the research on the propagation of global shocks in the small open economy the common approach is to form a two-block SVAR or FAVAR model (see Boivin and Giannoni, 2007, Maćkowiak, 2007, Jääskelä and Smith, 2013, Aastveit et al, 2011, Charnavoki and Dolado, 2014or Globan et al, 2015, where the first block consists of global variables, while the second block captures the domestic ones. The variables in the foreign block are assumed to be exogenous in respect to the domestic block.…”

Time Series Modeling of Inflation and its Volatility in Croatia

“…Besides the high euroization in the financial system, Croatian economy is characterized as a highly open and having relatively high level of external debt as well. Globan et al (2016) empirically analyzed the do-mestic and external inflation determinants for eight non-Eurozone new EU member states including Croatia, using a structural vector autoregression model and found that foreign shocks are a major factor in explaining inflation dynamics in the medium run. This might be the case due to relatively high imports in Croatia and so inflation in Croatia is determined by costs and not by money supply.…”

Determinants of Inflation in Europe – A Dynamic Panel Analysis

“…There is a consensual approach in the literature to the empirical literature. The diversity exists in different approximations of the variable used, including: index of nominal exchange rate (Tasci et al, 2009;Globan et al, 2016), index of real effective rate (Sek et al, 2015;Deniz et al, 2016) or changes in movement of nominal and real rate alternatively (Staehr 2010;Mohanty & Klau, 2001). We additionally observe the impact of exchange rate regime classification to the movement of prices (variable PFW -policy framework), which is an approach widely justified in the literature (e.g.…”

“…Thus, we include in the model a variable denoted as MSG 7 (growth rate of monetary aggregate M2), which is important from the aspect of analysing the control of monetary policy over coordination of money. The most widely used form of this variable in the literature is the growth of monetary aggregate M2 8 (Inoue, 2005;Begovic, 2014;Mahabadi & Kiaee, 2015;Deniz et al, 2016;Cardoso & Vieira, 2016), monetary aggregate M1 (Ghanem, 2012;Globan Arcabic & Soric, 2016), M1/ GDP (Catao & Terrones, 2015), including also M3 (Agayev, 2012). 9 We follow the transition literature which consistently takes into account different institutional effects on inflation (e.g.…”