Inflation Regimes and the Transmission of Positive Nominal Demand Shocks to the Price Level

Abstract

We investigate the inflation rate at which a positive nominal demand shock (such as increased government spending or expansionary monetary policy) pass-through to the consumer price level is minimal. Evidence in this chapter shows that the pass-through is less than one and the magnitudes of the pass-through decline depending on inflation regimes. High inflation regimes are associated with a high pass-through compared to when inflation is low and particularly below the 4.5 per cent inflation threshold. This shows that the pass-through of nominal demand shocks to consumer price inflation is bigger in the high inflation regime. The speed of adjustment or the error-correction coefficient is relatively large in the high inflation regime than in the low inflation regime. Furthermore, evidence shows that inflation fluctuates more in the high inflation regime than when it is below the 4.5 per cent inflation threshold. This shows that inflation tends to be rigid in the low inflation regime than in the high inflation regime. This indicates that policymakers have considerable scope to engage in short-run demand management policies in the low inflation regime than in the high inflation regime. Therefore, nominal demand shocks are unlikely to generate much inflation in the low inflation regime relative to the high inflation regime.

Appendix

Table 25.5 Unrestricted cointegration rank test (trace )

Table 25.6 Unrestricted cointegration rank test (maximum eigenvalue)

Table 25.7 Estimates of the long-run coefficients based on the inflation regimes

Table 25.8 The speed of adjustment or error-correction

Fig. 25.8

Robustness based on 1980Q1–2017Q1 sample. (Note: The grey-shaded bands denote the 16th and 84th percentile error bands. Source: Authors’ calculations)