Inflation adjustment in the open economy: an I(2) analysis of UK prices
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- Nielsen, H.B. & Bowdler, C. Empirical Economics (2006) 31: 569. doi:10.1007/s00181-005-0030-9
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This paper estimates a cointegrated vector autoregressive (VAR) model for UK data on consumer prices, unit labour costs, import prices and real consumption growth. The estimated VAR indicates that the nominal variables are characterised by I(2) trends, and that a linear combination of these processes cointegrate to I(1). This supports an analysis in which I(1) and I(2) restrictions are imposed. A key finding is that an increase in real import prices reduces productivity adjusted real wages, such that the change in domestic inflation is moderated. This may explain why the depreciation of sterling in 1992 left inflation unchanged.