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The Condemned Live Longer – New Evidence of the New Keynesian Phillips Curve in Central and Eastern Europe

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Abstract

We study inflation dynamics in emerging, small open economies of Central and Eastern Europe (CEE) and find new empirical evidence of the existence of the New Keynesian Phillips Curve (NKPC). Acknowledging specification uncertainty, a comprehensive set of alternative proxies for the NKPC’s components is assessed. Our results indicate the superiority of labor market measures for economic slack, support the use of survey inflation expectations and confirm the NKPC’s open economy version. Further, we investigate the stability of the NKPC over time, performing Bayesian inference in a time-varying parameter stochastic volatility version of the model. The results do not suggest the NKPC to have flattened in CEE challenging recent evidence in advanced economies. Inflationary dynamics have not decoupled from the state of the domestic economy. Therefore, a balanced approach to monetary policy which neither neglects the domestic nor external drivers of inflation and focuses on anchoring inflation expectations is well justified.

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Notes

  1. Table 3 in Appendix A provides a comprehensive overview of the variables used, alongside a description and sources. Descriptive statistics are shown in Table 4. Inflation rates and labor market slack measures are shown in Figs. 7 and 8.

  2. As tax changes tend to be more closely associated with institutional rather than economic factors, inflation rates at constant taxes are preferable over regular inflation rates.

  3. Adam and Padula (2011) further show that a theoretically grounded NKPC can be derived also if full-information rational expectations do not hold, when survey based inflation expectations satisfy the law of iterated expectations. Coibion et al. (2018) find support for the US. Further, it should also be stressed that firm inflation expectations would be the preferred measure in empirical representations of the NKPC but lack availability.

  4. According to theory it should reflect the deviation of output from the level when all prices are perfectly flexible.

  5. Two-quarter moving averages are applied to smooth the otherwise volatile time-series of the external factor. The real effective exchange rate (REER) has been inverted.

  6. Alternative specifications, which also focus on the open economy aspects of the NKPC, further distinguish between domestically and foreign produced intermediary goods as drivers of domestic inflation (Rumler 2007) and the possibility to substitute imported intermediary goods for domestic labor (Leith and Malley 2007).

  7. We apply the “rule of thumb” approach by Staiger and Stock (1997) to the Kleibergen-Paap Wald statistic and identifying weak instruments at levels lower than ten.

  8. He asserts that labor market adjustment works through the intensive margin. A considerable influx of migrants from Ukraine (between 2012 and 2017 more than 2 million persons received EU residence permits in Poland) might have further inflicted the relationship between labor market slack and inflation (Eurostat, Population & Social Conditions, Asylum & Managed Migration, Residence permits).

  9. The statistical significance of external supply shocks also emphasizes the monetary policy trade-off between stabilizing inflation and stabilizing the real economy. As Blanchard and Galí (2007) famously argued for the divine coincidence’s non-existence under real wage rigidities, external inflationary drivers would trigger a restrictive monetary policy reaction within a strict inflation targeting framework. Small open economies are, therefore, well advised to follow a more flexible approach which however does not jeopardise the inflation target’s credibility over the medium term.

  10. Figures 1 and 2 only report the coefficient estimates of the respective variables of interest. A complete set of estimation results of the underlying GMM regressions can be found in the online appendix.

  11. Due to its countercyclical characteristics, the labor share is not without criticism as a standard proxy for marginal costs within the NKPC framework (Rudd and Whelan 2005).

  12. Reported coefficients in Figure 2 correspond to the empirically motivated terms of trade specification (first difference of terms of trade). Theory consistent specifications as in Mihailov et al. (2011a, 2011b), which add the discounted next-to-current period change in terms of trade, do not differ materially, except for Hungary where the coefficient increases and gains statistical significance. Results can be requested from the authors.

  13. To be consistent with the benchmark specification, inflation expectations are instrumented with 2 or 4 lags.

  14. For more details about the model see the online appendix.

  15. Bitto and Frühwirth-Schnatter (2019) note that the sparse TVP framework reduces time-varying coefficients to static ones in case the model is overfitting, what is – given the low number of covariates – a minor risk in our model.

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Acknowledgements

We would like to thank Sylvia Frühwirth-Schnatter, Katrin Rabitsch, Fabio Rumler, George S. Tavlas and two anonymous referees for very helpful comments.

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Authors and Affiliations

  1. Raiffeisen Bank International AG, Am Stadtpark 9, 1030, Vienna, Austria

    Franz Xaver Zobl

  2. SanusX GmbH, Vienna, Austria

    Martin Ertl

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  1. Franz Xaver Zobl
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Correspondence to Franz Xaver Zobl.

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Appendices

Appendix 1: Data & Descriptive Statistics

Table 3 Variable Description & Sources
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Table 4 Summary Statistics
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Fig. 7
figure 7

Inflation rates

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Fig. 8
figure 8

Labor market slack

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Fig. 9
figure 9

Measures of trend inflation

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Appendix 2: Robustness checks material

Table 5 Hybrid New Keynesian Phillips Curve
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Table 6 Core inflation specifications
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Table 7 Alternative instrument specifications
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Table 8 OLS estimates of Inflation Gaps
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Table 9 GMM estimates and average posterior means of TVP
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Zobl, F.X., Ertl, M. The Condemned Live Longer – New Evidence of the New Keynesian Phillips Curve in Central and Eastern Europe. Open Econ Rev 32, 671–699 (2021). https://doi.org/10.1007/s11079-020-09604-4

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