Phillips Curve Lithuania
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Inflation and unemployment relationship: estimating
the Phillips curve for Lithuania
Mantas Bambalas, student id: 0909896
0. Introduction1. Origins of the Phillips Curve, Its Ups and Downs .............................. 31. Origins of the Phillips Curve, Its Ups and Downs...................................................... 42. Lithuanian Economy................................................................................................... 7
2.1 Agriculture ............................................................................................................ 82.2 Industry and trade ................................................................................................. 92.3 Labour market..................................................................................................... 112.4 Inflation, earnings, and monetary-fiscal policy .................................................. 15
3. Theoretical framework.............................................................................................. 213.1 Original Phillips curve .................................................................................. 213.2 The new Phillips Curve and its Shortcomings.............................................. 233.3 The new Keynesian Phillips Curve by Gali and Gertler............................... 26
4. What will be done next ............................................................................................. 27References......................................................................................................................... 27
1. Origins of the Phillips Curve, Its Ups and Downs
In 1958, an influential New Zealand economist Alban W. Phillips published a paper, in which he wrote about the relationship between the wage inflation and the unemployment rate. This relationship was discovered for UK data between 1861 and 1957. Later, the above mentioned relationship was named as the Phillips Curve. In 1958, A. W. Phillips(1958, p. 284) raised a hypothesis that “When the demand for labour is high and there are very few unemployed we should expect employers to bid wage rates up quite rapidly, each firm and each industry being continually tempted to offer a little above the prevailing rates to attract the most suitable labour from other firms and industries. On the other hand it appears that workers are reluctant to offer their services at less than the prevailing rates when the demand for labour is low and unemployment is high so that wage rates fall only very slowly”. Relying on this hypothesis, he thought that there should be a non linear relationship between rate of change in money wages and unemployment. As a result of this, the main purpose of his paper was to examine whether or not the hypothesis that the change in money wages can be explained by the level of unemployment can be supported using statistical evidence. However, A. W. Phillips(1958, p. 284) emphasized that this study applies to UK “…except in or immediately after those years in which there was a very rapid rise in import prices…”. A. W. Phillips introduced this limitation since a very rapid rise in export prices would lead to the situation where cost of living adjustments is an important factor influencing the rate of change in money wages. In other words, rapid rise in import prices would increase a cost of living. Shortly, taking into account these years of rapid import price rises would have resulted in statistical failure of the above mentioned hypothesis by A. W. Phillips.
Figure 1.1. A relationship between the rate of change of money wages and unemployment. Originally presented by A. W. Phillips in 1958.
Phillips (1958) concludes that statistical evidence support his conclusions in years without a rapid rise in import prices, even though this occurred very rarely (during the war etc). However, he notes that his conclusions are tentative and more advanced and detailed research should be done on this area of interest.
Soon after the original paper was published by Phillips, other researches estimated his model for a number of countries. Most of them involved estimation between the general price inflation rate and unemployment rather than between the rate of change of money wages and unemployment. That is, researched tried to find out whether or not a low rate of unemployment results in high inflation and vice versa. An article by Kevin D. Hoover(Library of Economics and Liberty) reminds that a close fit between the data and estimated curve encouraged some of the economists to treat the Phillips curve as a policy tool. That is, they thought that a government can take some actions simulating economy to reduce unemployment, even though the convexity of the curve resulted in high costswhen the intent was to reduce a low level of unemployment. However, economists such as Milton Friedman and Edmund Phelps independently criticized the above mentioned theory. They both argued that the government could not permanently keep a low level of unemployment at a cost of high inflation. A key idea of their view was that there exists a natural level of unemployment at which any attempt to reduce the latter using any fiscal or monetary policy results just in temporal changes. Analyses by the above mentioned authors provided a distinction between the so called “short-run” and “long-run” Phillips curves. A Noble prize winner Robert Lucas has published some critique1 regarding the macroeconomic theories. His critique was a primarily tool for economists to express skepticism on the Phillips curve, especially its future. Indirectly challenging the Phillips curve, he stated that you could not make policy decisions based on historical data(because people had particular expectations). In other words, relationships described by the past data would not necessarily hold in the future as a result of change in expectations (Lucas, 1976). An empirical support to Lucas’s Critique was 1970s. Stagflation2 in 1970s showed that that a high rate of inflation not necessarily results in a low level of unemployment. In the US, when the average inflation rate rose from about 2.5% in the 1960s to around 7% in the 1970s, the level of unemployment changed completely contrary to the original Phillips curve: instead of falling, it actually rose from about 4% to above 6%. This phenomenon has provided a striking confirmation of the fundamental point raised by Friedman and Milton. At the same time, it was a break point when the original Phillips curve seemed to be no longer reliable. This is known as an empirical challenge to the Phillips curve. However, this is not surprising since the hypothesis provided by A. W. Phillips did not have a strong theoretical background. A central tenet of both Friedman’s and Phelps’s analyses are now accepted by most economists: “there is some rate of unemployment that, if maintained, would be compatible with a stable rate of inflation. Many, however, call this the “nonaccelerating
1 Lucas, Robert (1976), "Econometric Policy Evaluation: A Critique", in Brunner, K.; Meltzer, A., The Phillips Curve and Labor Markets, Carnegie-Rochester Conference Series on Public Policy2 A phenomenon when both a high level of unemployment and a high rate of inflation exist is called stagflation. More about this can be found in J. Bradford DeLong, “Supply Shocks: The Dilemma of Stagflation”, 1998.
inflation rate of unemployment” (NAIRU) because, unlike the term “natural rate,” NAIRU does not suggest that an unemployment rate is socially optimal, unchanging, or impervious to policy.” (Library of Economics and Liberty). SomeDespite a success of the theory by Milton and Friedman, some of the “new Keynesian” economists hold that there only a weak tendency for an economy to return to NAIRU. According to them, there is no such phenomenon as natural rate of unemployment to which the actual rate tends to return. “New Keynesian” economists argue that when actual unemployment rises and remains high for some time, NAIRU also rises. (Library of Economics and Liberty). Continuing the “new Keynesian” topic I will approach the main topic of this paper – the New Keynesian Phillips curve.
Figure 1.2. Long-run and short-run Phillips curves
1970s has been a decade of challenges for Keynesian economics. Whole basis of this economics became questionable. That is, an assumption that monetary policy could systematically affect output even in a short run. All these problems has been raised by a school of thought of rational expectations, led by Robert Lucas and Thomas Sargent. The above mentioned problems of absence of rational expectations and inadequate expectations modeling have been pushing Keynesian economists to find models that incorporate rational expectations. Moreover, monetary policy changes according to these models have been expected to have at least short-run effect. Here comes the new Keynesian economics (pioneered by Ball, Mankiw, and Romer 1988). According to Gordon (1990), new-Keynesian economics has a main task – to explain why price changes do not mimic changes in nominal GDP. This is also called as price stickiness.(2005) briefly explains what it means: ‘Without some type of price rigidity, it is difficult to rationalize the idea that there can be periods during which factors of production, such as labour, are under-utilized, with aggregate output being below its so-called potentiallevel. Once we assume that at least some prices are rigid, then not all markets are clearing instantaneously and aggregate output may sometimes be below what would obtain when all prices move flexibly. Also, with sticky prices, an increase in the money
stock can produce a short-run increase in real spending power and thus can boost real output” Price stickiness is an important part of monetary models of business cycles.Instead of originally explaining a relationship “between the change in nominal wage rates and the level of unemployment, it has become common to use the Phillips-curve terminology to label any relation between the rate of change of nominal prices or wages and the level of a utilization variable like the unemployment rate or detrended output” (Gordon, 1990). One of the new Keynesian models analyzes Phillips curves using inflation and output. However, papers by Gali and Gertler (1999), Gali et al (2001) offer to replace output measures by marginal costs and support their theoretical views by empirical estimations for Euro are and the U.S. This paper mainly focuses on the models explored by Gali and Gertler (1999). More about them is in the following chapters.
2. Lithuanian Economy
Many economists tried to apply the Phillips curve inflation-unemployment relationship to other developed counties in the same manner, as has been done for the UK by Phillips (1958). However, Lithuania is a completely different case. It has survived several occupations by Germany and the Soviet Union. The latter influenced Lithuania’s development in many ways, including economic factors, traditions, and manners. Soviets occupied Lithuania after the Second World War and just as late as in March 11, 1990, Lithuania announced the Act of the Re-Establishment of the State of Lithuania. However, it took a while until the soviet troops have left the country. Therefore, instead of having old economic traditions, Lithuania had a transition economy. In other words, when Lithuania became independent, it had to change from centrally planned economy to a market economy. Nsouli (1999) points out several criteria that should be done in the transition process:
1. A radical transformation of the role of governments. In order to function well, market economies need “governments that are efficient and evenhanded in establishing and enforcing essential rules for promoting widely shared social objectives, for raising revenues to finance public sector activities, for spending these revenues productively, for bringing required corrections to and controls over the working of the private sector, and for enforcing contracts and protecting property.”
2. An improved process of privatization. Major state – owned companies should be sold to private capital owners (particularly foreign investors) in order to make those companies more efficient, get some money from privatization and eliminate loses that are created by inefficient management of such enterprises. Nsouli (1999) emphasizes that the reallocation of ownership should avoid “the transfer of labor and social obligations of old firms to new owners“.
3. A financial sector reform that enhances growth. The main idea of such reform would be to improve the intermediation process and to increase efficiency and control in the allocation of financial resources. In transition economies, the latter is often used inefficiently, with the strong impact of corruption and influence of powerful individuals. Giving an example, such reform should give more
autonomy to central banks and offer a competitive environment to foreign financial institutions. Moreover, an effective implementation of strong prudential regulations is also one of the key components in many transition economies.
4. The income adjustment. Severe inequalities of income have to be tackled. This should appear as a result of increased competition and institutional changes, though it will take time.
5. Macroeconomic stabilization. The main attribute of it is that the macroeconomic stabilization will sustain the recovery of economic activity, its structural reform. Even more, it is essential to sustained growth. According to empirical evidence, low inflation is a sign of faster economic growth. Moreover, moderate inflation rates are also very important to those transition countries that are willing to join the European Union.
Later on, a brief summary will be presented, how well these criterions have been met in case of Lithuania. Continuing the transition economy topic, it is worth to mention what was the situation in Lithuania at the beginning point of transition. First of all, immediately after regain of independence, Lithuania had to choose which direction it wants to move: toward multi-party democracy and competitive economy, or to remain closed, heavy regulated economy (Grennes, 1994). The choice has been made and was undoubted – to move towards western style economy.
Large collective agricultural farms have been split between families (or individual farmers) giving them what has been earned. In such way some got a tractor, some a piece of a building etc. Nationalized lands step by stem were given back to their owners. However, this led to agricultural productivity decrease in the following years. Before transition in 1989, agricultural production was 25 percent of gross national product in Lithuania (Litaunus, 1993); therefore it is an important aspect to address. During transition period, this share of GDP was decreasing over time (see figure below). In 2009, agricultural production was only about 3.7 percent of GDP (in year 2009 prices) . Under the Soviet system, most of the agricultural production made in collective farms was heavily subsidized. However, individuals were not applicable to get any subsidies at all. Such system did not encourage working efficiently. For example, average harvest amounts from a hectare were much lower than those in independent western countries. A serious hurdle in the way towards efficiency was a lack of modern machinery. All collective farms were using Russian tractors, drills, combines etc. These items were very primitive, not fuel efficient, and used to brake down very often. A good standard of farming was not achievable due to such shortcomings. A lack of professionalism and serious attitude to work from workers was also a huge problem. Under the Soviet system, collective farms were far above the optimum size. After regain of independence and the separation of collective farms, individual farms were much smaller than the optimum size and this has not changed dramatically till our days. The removal of subsidies to energy, production, and food increased food prices. Duzinskas (1992) reminds that By November 1992, after partial removal of subsidies, the average consumer had to spend about 64 percent of his budget on food. Several years after the reestablishment of independence,
agriculture improved. However, farms were short of modern machinery, even the used one was too expensive to purchase. Just after year 2000 some of the richest and biggest farmers were able to buy new tractors and other machinery. The year 2004 was a breakpoint in this sector. Joining the European Union was a dream come true for many farmers. Subsidies for grass, crop and cattle was a judge help and a rich source of income. Compensations for purchase of new machinery opened a way to upgrade farming machinery. Most of the big farms now have very modern tractors, combine harvesters etc. Together with skilled staff they are able to produce as good production as the farmers from western countries.
Agricultural production share of GDP (Lithuania)
1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009
Figure 2.1. Agriculture production share of gross domestic productof Lithuania during the period 1997 to 2009.
2.2 Industry and trade
As in all countries, industry is very important branch of economy. Under Soviet system, Lithuania had several major disadvantages in industry. First of all, before Soviet occupation Lithuania was an agrarian country. However, head officers from Moscow thought it needs to be industrialized, though it was not compatible with the integrity requirements of Lithuanian economy. Second, raw materials and other things that industry needed, such as crude oil, gas, steel (and other metals), cotton, and other raw materials were imported from theSoviet Union, thus it was the only source of the above mentioned materials. Moreover, during the economic blockade3 in 1990, this appears to be a severe problem. Economic development following this scenario was not natural. Some new industry branches have been established in the country, including fabrication of electronic devices, machinery and equipment, chemic and military production. However, old branches such as food industry were not forgotten. Third, the real capital under the Soviet system was created ignoring the true advantages of Lithuania and the economy integrity. This resulted difficulties during the transition period after year 1990.A period between 1990 and 1994 was the period of recession, mainly due to the economic blockade. Just after year 1995, economic situation became better bringing
3 Economic blockade of Lithuania started in 18 April, 1990 and lasted for 74 days. The Soviet Union stopped providing Lithuania with crude oil, goods and raw materials. Fuel sales were limited. Using such actions, the Soviet Union demanded to cancel all resolutions that mean a will of reestablishment of independence.
together the economic growth. This also brought an accelerating investment process and modernization of manufacturing technologies. Despite this, currently about three quarters of Lithuanian industry is occupied by the companies which use old technologies and only about a small piece (about 5%) of the Lithuanian industry belongs to modern technology firms. During almost a decade between 1980 and 1989 industry production was about 36 percent of the gross domestic product. However, after reestablishment of independence and economic reform it has shrank to 23 percent in 1994. The recession in the latter period was also a significant contributor to such decrease in industrial productivity. In the figure below we can see that in later years starting with 1997, industrial production was about 20 percent of the gross domestic product of Lithuania.
Industrial production share of the GDP in Lithuania
1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009
Figure 2.2. Industrial production share of gross domestic productof Lithuania during the period 1997 to 2009.
A minor slowdown of the industrial production is visible in 1998 (during the Russianfinancial crisis). Russia was the main export country; therefore the financial crisis in Russia had a significant impact on Lithuanian economy. However, in 2000 all problems seem to be solved and industrial production was above 20% of the GDP.Despite it disadvantages, the Russian financial crisis has benefited Lithuanian economy in terms of export - Lithuanian businessmen redirected export flows to western countries. Situation started to change after year 2004. Obviously, after joining the European Union in 2004 Lithuania achieved a right to freely export its production to other EU counties. On the other hand, this seems to work the opposite direction and the local products in Lithuania have been changed by the imported ones from other EU countries. This thought could be underpinned using the figure below. Foreign trade deficit looks steady and fluctuates between -2000 millions and -8000 millions of Litas for almost a decade starting with 1995 and ending with 2004. However, starting with year 2004, a sharp decrease in the foreign trade deficit is obvious and it reached its peak in 2007, amounting to -18000 millions of Litas. As it was mentioned before, such increase in foreign trade deficit was determined by improved conditions regarding the foreign trade. After joining the EU in 2004, Lithuania has opened its borders to all EU members and the results are clearly visible.
Some drastic changes are visible between year 2008 and 2009. The foreign trade deficit has decreased almost four times. There are two main reasons for this.Fist, at the end of 2007, Lithuania joined the Schengen Agreement which allows foreign trade without checking at the border control (just between the countries belonging to Schengen Agreement).Second, import volume has decreased due to first signs of global recession. The most sensitive import items were crude oil and ground transportation.
Foreign trade deficit in Lithuania (millions of national currency)
Figure 2.3. Foreign trade deficit in Lithuania during the period 1995 to 2009.
During the transition, some attention has been paid to privatization, but much more should have been paid. A part of the industrial companies have been privatized by Lithuanians, although the foreign capital is preferable during the privatization process (Nsouli, 1999). Nonetheless, state-owned enterprises continued to dominate in many industries (Grennes, 1994). As one of the major disadvantages of privatization, could be named the doubtful origin of the money. Organized crime bosses accumulated huge amounts of money which they used for purchases. However, currently the biggest industrial company (“Mazeikiu nafta”, the oil refinery) belongs to the foreign capital. Another “monster” (“Achema”, fertilizer manufacturer) is being owned by the richest Lithuanian.
2.3 Labour market
Labour market situation in Lithuania before and during the transition is one of the most related topics to the original Phillips curve, because unemployment is what was the most interesting to researches. Obviously, there are no data sets about the unemployment rates in Lithuania under the Soviet system. But it is important to note that almost all who were willing to work were able to do that. To be more specific, everyone who studied was guaranteed a workplace after studies, regardless whether or not this type of profession was demanded in the market. Disabled persons were also guaranteed at least minimum salaries. The most distinct disadvantage of working environment was that wages were not related to the market demand of particular skills (Grennes, 1994). Physical work was paid more than the mental. For example, people working in construction, industry, transport were paid more than those who worked as scientists, engineers, physicians, although the former lacked even a
secondary school education (World Bank, 1993). Such system created a tendency for the emigration of bright people and a lack of incentive to gain good skills and high education. Overall, the absence of incentive has resulted in poor economic results of many industries and enterprises. No one was awarded for good results; therefore most of the companies were doing poorly. Soon after the reestablishment of independence, the centralized supply of raw materials, power sources and trade of goods has collapsed. Changing from planned economy to market economy (in transition progress) crated conditions for rise of unemployment. A number of workless people started to increase year by year (see figure below). Due to limited sources of data it is not possible to see how the rate of unemployment has changed from 1991; however, we can see that it had a tendency to increase until 2001. It is interesting no note that these figures do not reflect the real level of unemployment. According to the Lithuanian department of statistics, the real level of unemployment can be about 2 times bigger than the Lithuanian jobcentre announces. This happens because the official unemployment figures by the Lithuanian jobcentre are constructed by counting those people who register as unemployed. However, these people appear to be a minority. There are many more who do not look for a job or does this individually through the media, private companies etc. Unfortunately, the Lithuanian department of statistics and the Lithuanian jobcentre provides different periods for unemployment figures; therefore it is not possible to compare them for the whole period (1993-2009). Nonetheless, rates provided by the department of statistics are a better proxy for the real unemployment rates.
Annual unemployment rates in Lithuania (1993-2009)
According to the jobcentre According to the departament of statistics
Figure 2.4. Annual unemployment rates in Lithuania during the period 1993 and 2009.
The unemployment rates jumped up soon after 1998. As mentioned before, it was also an impact of the Russian financial crisis in 1998. This crisis was followed by a sharp recession in Lithuanian economy. This recession has lasted for the whole year. Many companies exporting to Russia had payment delays and were not able to work normally. Consequently, production volumes has shrank, some of the workers has been fired or forced to work less than a full time work, or take unpaid holidays. As a
result of this, companies have stopped functioning normally and this reflected in unemployment figures: a rise in unemployment rate, increased fires of groups of workers. In addition to the above mentioned problems, there was also a number of other factors that determined increased unemployment. A big imbalance between the qualifications and market demands is worth mentioning. Step by step a demand of unqualified workers has decreased. Unqualified workers were getting much less offers and more often just for seasonal work. At the same time, a demand for well educated and skilled workers has risen. Employers were raising high entry requirements for new workers; a need of computer literacy was also getting more important. Until 2002, the economic and juridical environment for small and medium businesses was very complicated: a large number of firms have bankrupted or stopped working, businessmen lacked information and knowledge, there was no support by the government or this support was ineffective, business development in regions was imbalanced. All these problems were started to solve by the Lithuanian government in 2001-2004 by enforcing the employment incentive program. The main idea of the latter was to expand the development of small and individual firms, effectively use human and other local material resources, seek to improve the speed of economic development, and create friendly conditions for employment incentives. This program allowed companies more easily access the financial aid sources, create new workplaces, develop an infrastructure for business aid which creates a friendly environment for new companies and existing ones, and motivate the establishment of new companies that specializes in unconventional business. Thanks to the employment incentive program, over a million thousand unemployed people have been involved in this program during the period 2001 to 2004. A half of them got a workplace. Due to the above mentioned reasons, from 2002 unemployment rate started to decrease (see figure 2.4). In 2004, the unemployment rate was 6% smaller in comparison with rate in 2001, when the unemployment rate reached its peak at 17.4% (according to the department of statistics). A decrease in unemployment rates was also influenced by better macroeconomic situation: low inflation (more about this later), smaller budget deficit, increased real gross domestic product. In 2004, joining the European Union had a big impact for unemployment rates. It became legal to work in many EU counties and United Kingdom. Many unemployed and poorly skilled workers took a chance and emigrated. However, a number of well educated and skilled workers also left the country looking for higher salaries. As a result of this, emigration was an important factor that helped to reduce unemployment. If we look at the figure below, we will see that emigration jumped up immediately after joining the EU in 2004. What is the most interesting, a number of planned emigration (those who declared their emigration) is stable over time and seems not to change even after 2004. However, seasonal, short time emigration (to live in a foreign country just for a limited period) increased a lot during 2004 and 2005. In addition to emigration, membership in the EU had another impact to unemployment rates. Lithuania has received a lot of financial support from the EU. Starting with agriculture, businesses, and finishing with schools and hospitals renovation. All this support created favorable conditions for business development. This development has created a number of new workplaces.
Emigration in Lithuania (2001-2009)
2001-2002 2003 2004 2005 2006 2007 2008 2009
Total number of emigrants Emigrants that decrared their emigration
Emigrants that did not declare their emigration
Figure 2.5. Emigration figures in Lithuania during the period 2001 to 2009.
Increasing economic growth has resulted in good business situation. Ignoring all warnings about the overheating of economy, people were borrowing a lot and buying a lot. All these borrowing-spending habits along with other purchases of goods and services have created am abnormal economic activity that has resulted in economy overheating followed by global recession in 2008. If we look at 2.4, we will see the consequences of the global recession: the unemployment rate started to rise in 2008 and almost doubled in 2009. Influencing conditions are obvious:
1. Increased and new taxes affected the rational expectations of people. They started saving instead of borrowing and spending. This has resulted in smaller purchase power.
2. Lower people purchase power was the main factor for reduced demand for goods. Companies received less income, therefore had to rearrange their administration. In addition, higher tax rates made their situation even worse. As a result of this, some of the companies have fired many employees leaving only the best ones.
3. The real estate crisis changed the value of newly built flats – their prices shrank almost two times. Moreover, almost construction industry has stopped working. Many building specialist were left unemployed.
4. A law of obligatory health insurance forced many unofficial workless people to register at the local jobcentre. Otherwise they would need to pay health insurance contributions. This law also resulted in an increase of the official figures.
5. New laws affected not even the existing businesses, but also the new ones. New businesses had no favorable environment to establish and develop. Contrary, high taxes and huge bureaucracy were those forces that prevented from creating new businesses and new workplaces.
According to the Lithuanian department of statistics, in Q1 2010, the unemployment rate in Lithuania was staggering 18.1 percent with the tendency to increase.
2.4 Inflation, earnings, and monetary-fiscal policyEven after declaration of reestablishment of independence in March 1990, Lithuania continued to use the Russian currency unit ruble as its monetary unit. This lasted until October 1992, when Lithuania suffered from huge inflation. Inflation increase started in 1990, when it was 16.1 percent and continued to increase during 1991 (224.7percent) and reached its highs in 1992, hitting massive 1162.14 percent (inflation calculated using the CPI). This kind of inflation was an enormous shock to such inexperienced small country. The heads of government were not used to so high inflation and did not have a clear action plan adapting to a high inflation rate. In 1993, they made a decision to replace the ruble by temporary coupons (talonas); inflation became stable at around 20 percent per month or over 200 percent per year in the first half of 1993 (Grennes, 1994). Since Russia used its monetary policy to support and finance inefficiently managed, unprofitable state-owned companies, and finance the government’s budget deficit, all ruble holders suffered from inflation as a kind of tax.This was happening, because “inflation reflected rapid growth in the quantity of money created by the central banks of Russia and Lithuania” (Lituanus, 2003). As long as Lithuania used the ruble, this also applied to it. In 1993, Lithuania introduced a new national currency litas. It was done much later comparing to the other two Baltic States (Latvia and Estonia). This delay in abandoning the ruble was due to a local dispute between the parliament and the former head of the bank of Lithuania. Just after he was forced to resign in 1993, and a new head of the bank of Lithuania replaced him, there was no holdback towards introducing the litas. The above mentioned delay in carrying out the currency reform introduced uncertainty which was not necessary, maybe even harmful. This uncertainty probably complicated development of the Lithuanian financial sector which was very primitive itself. No wonder that there was no foreign bank in the middle of 1993 – delaying monetary reform may have prevented or at least discouraged their entry (Grennes, 1994).
Annual inflation rates in Lithuania (1991-2009)
Figure 2.6. Annual inflation rates in Lithuania during the period 1991 to 2009.
Annual inflation rates in Lithuania (1996-2009)
1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009
Figure 2.7. Annual inflation rates in Lithuania during the period 1996 to 2009.
In two figures above, we can se the development of inflation rates over the past two decades, since the reestablishment of independence of the republic of Lithuania. I already mentioned the inflation shock in 1992. The latter was mainly caused by several reasons: a decision of price liberalization (the government controlled only energy, accommodation, public utility, public transport, and other service prices), uncontrollable high cash flows of low value rubles, emission of talonas and its value decline, decisions made by enterprises to solve their problems by increasing prices, fluctuation of energy prices, and citizens’ will to spend low value money as soon as possible. All these reasons have created a tendency for price growth and twisted inflation spiral. One of the worst consequences to the citizens was the value of savings kept in the banks. Obviously, such enormous inflation and introduction of new currencies reduced the value of these savings by many times. Finally, when litas was introduced in 25 June, 1993, 100 units of talonas (equal to 100 rubles) were exchanged to 1 unit of litas. In other words, savings have lost about 99% of their value. Using a strict monetary policy Lithuania managed to reduce inflation down to 188.86 percent in 1993. In 1994, the inflation rate shrank even more to 45.09%. This fall can be explained by the law of litas’s credibility, which has legitimized the activity of a currency board. This law was adopted in March 1994 and entered into force in April 1, 1994. According to this law, all litas units that were in circulation must have been cover by gold and foreign currency reserves. Moreover, litas was related to U.S. dollar using a fixed ratio – 4 litas for 1 U. S. dollar. This fixed dollar-litas ratio limited monetary policy influence to economic processes. The model of currency board allowed eliminating one of major factors – money volume influence to the inflation, because in the presence of fixed currency rate, money volume in the economy is determined by the money demand. Insufficiently evaluated real litas’s rate was an important factor determining high inflation even under the model of currency board.Fixed litas’s rate stopped the increase of its nominal value, therefore it was impossible to achieve a balanced exchange rate of its real value. As a result of this, the increase in local prices became the major tool towards such balance. Since introduction of the currency board, the inflation process can be defined as a consistent approach towards a low inflation of Western countries. Although a sharp decline in inflation rates was expected, it took over three years for inflation rate to reach one-digit. As mention before, strict macroeconomic policy helped to reduce inflation to 37.5 percent in 1995 and 13.1 percent in 1996. During the period 1994-1996 inflation was mainly caused by the
increase in food and non-alcoholic drink prices. It is worth to mention that despite a slower price increase in 1994, this year brought more painful social consequences than the 1992. In 1997, the annual inflation rate was 8.36 percent. Since the introduction of litas, it decreased about ten times over 4 years. Inflation was mainly caused by increase in food, non-alcoholic drinks, and energy prices. Later on, in 1998, inflation rate dropped several times in comparison with last year’s inflation and reached amazing 2.42 percent. Such sharp decrease in the inflation rate was mainly caused by cheaper food prices. Higher crude oil prices in 1999 and 2000 pushed the inflation up a little bit. Higher petrol prices were followed by increase in many consumer prices due to increased freight charges (see figure 2.7). September 11, 2001 terror attacks in the United States affected most of the world. In Lithuania, they resulted in price decrease and reduced consumer price dynamics. There was no room for inflation development even in 2002 and 2003: a sharp competition between companies in many economic sectors did not allow them to put additional manufacturing expenses into the final prices. An increase in import prices was limited the relatively expensive litas in comparison to euro and dollar. Low inflation prevented workers from demanding higher salaries in order to compensate increased living expenses. Similar demands were also absent due to a high level of unemployment. From figure 2.7, we can see that year 2002 and 2003 distinguish by negative inflation (disinflation). Disinflation was mainly cause by a huge competition among supermarkets and mobile connection suppliers. This competition involves advertising, service quality, and prices of goods and services. Seeking for higher circulation, companies have changed the price level to the lowest possible just to cover manufacturing expenses and gain minimal profit. Such strict competition may have resulted in price levels that are below the cost price. Although this kind of competition benefits consumers, this effect is short time. Year 2004 again brought higher inflation. Increasing economic growth and gross domestic product tell about a better economic situation. Increasing wages (see figure 2.10) testifies about the increased purchase power of the citizens. This increased purchase power increases a demand of many goods and services. Membership in the EU from 2004 creates opportunities for people to use the EU financial support for many business areas. Sellers used such situation by increasing those prices which are popular among EU support recipients. Much influence to the inflation rates was made by increased real estate prices. In a short time real estate prices almost doubled and did not reflect their real value. In addition to above mentioned factors, an increase in crude oil price (see figure below) contributed a lot to the increased inflation rate. Increased fuel prices were followed by an increase in many services’ and goods’ prices, such as food and non-alcoholic drinks, accommodation, water, energy, gas, transportation, etc.
Figure 2.8. Crude oil prices (source: www.whatmattersweblog.com)
In 2009, the inflation rate dropped to an astonishing 1.28 percent. It is about 6 times less than it was in 2008. This massive fall was caused by the global recession which strongly affected Lithuania. Again, an important role is played by the crude oil prices. If we look at the figure above, we will see that in 2009, the crude oil price dropped more than by three-folds. Not getting into the details what have caused such an enormous decrease in crude oil prices, let’s see how it affected prices in Lithuania. Petrol prices have dropped almost by 30 percent. This drop was favorable to all transportation companies, including public transport. Along with smaller oil prices Lithuania got smaller gas prices. Due to bad economic situation in the country and intimidate government policy people stopped consuming as much as before. Higher tax rates and more strict economic environment along with decreased demand have cause worse financial situation for many firms. In order to survive they had to stop increasing prices or even to decrease them. A huge fall in real estate prices also contributed to so low inflation (see figure below).
Figure 2.9. Apartment price index in Lithuania (source: Ober-Haus)
In the report by Ober-Haus advisors (2009), we can find that “from the highest summarized apartment price level, which was achieved in December 2007, and until December 2009, apartment prices in major Lithuanian cities dropped 38.0% and return to the price level recorded in October 2005. Apartment prices went down 39.9% in Vilnius, 27.1% in Kaunas, 42.6% in Klaipeda, 42.5% in Šiauliai, and 44.0% in Panevežys. The real price index for major Lithuanian cities (after eliminating the impact of inflation) over the same period decreased somewhat more - 43.5%”.Starting to speak about earnings, a lack of statistical data does not allow us to familiarize with average earnings from 1991. A graph below offers graphical information about the change in earnings over the periods 1997-2009. Without getting into details, earnings increased over time more or less steady. As mentioned before, economic difficulties, high unemployment, and low inflation (sometimes even disinflation) prevented workers and their unions from demanding higher wages in the period between year 1999 and 2003. Starting with 2004, tendency of earnings increase is more explicit. Due to the above mentioned reasons, such as membership in the EU, recovering economy, etc, earnings started to rise and accelerated in 2007 and 2008. These facts should not surprise us. One of the reasons that cause such acceleration was a high inflation rate. Workers and their unions demanded higher wages to compensate their reduced purchase power. However, this continuous increase in earnings along with inflation created inflation spiral which had to stop during the global recession in 2008. We can see that the following year 2009 brought lower earnings and this was entirely logical issue. These cuts in earnings were started by individual enterprises. Some of the employees were fired; others went unpaid holidays or got lower wages. Public sector has not avoided reductions. Monthly salaries were reduced to many public service workers, excluding policemen, firemen, teachers, and doctors.
Figure 2.10. Average monthly earnings in Lithuania (Source: Statistics Lithuania)
In addition, a graph of nominal gross domestic product is presented bellow. It also illustrates all good and bad times that were covered in the previous analysis.
Figure 2.11. Gross domestic product in Lithuania (Source: Statistics Lithuania)
Going back to the criteria published by Nsouli (1999), most of them Lithuania has met. First of all, the government has transformed the economy from the collective economy to the market economy. As a result of this, many state owned companies works much more efficiently and spends their revenues productively. After this, privatization processes were very intensive and all major companies are now owned my private capital. A large share of the latter belongs to foreign investors. However, some privatization deals were not very clear and left some doubts. Some deals brought increased prices for goods and services. After this, financial sector reform can be said to be done during the transition. It has improved efficiency and control in the allocation of financial resources. Although the financial resources are used more efficiently, some of the faults occur and these problems require more attention in the future. Talking about the income adjustment, this problem has been solved completely. All positions in the public sector are paid by their importance and the skills required. Private sector’s earnings are slightly higher; however, increased competition does not allow them to distance. The most sensitive social classes are financially supported, medical care is guaranteed to almost all people, and pension system works well. Last but not least, the economy was stabilized. The membership in the European Union achieved. Moreover, some of the structural reforms have been made. Some of them simulated the economy growth, while the others helped to engage over half a million of workless people. Although the inflation rates were very high during 2007 and 2008, they were very all during the period 1998 to 2006. However, low inflation in 2009 and currently encourages being positive.
3. Theoretical framework
3.1 Original Phillips curve
There are a lot of versions of the traditional Phillips curve. Common specification can be found in Gali et al (1999) and has the following form
Where t denotes inflation, ty denotes the log deviations of real GDP from its long run
trend, and t denotes the error term. However, it is more advanced version of the curve.
In this case, let’s begin with the original Phillips curve, published by A. W. Phillips in 1958. This relationship was basically an empirical finding looking for the theoretical background. “The Phillips curve has been an empirical finding in search of a theory, like Pirandelo characters in search of an author” (Tobin, 1972). Initially, the Phillips curve was viewed as a relationship between the rate of change in money wages and the level of unemployment. Using the data from Lithuanian department of statistics, the following figure shows how well data from the sample period (1998-2009) fits the original Phillips curve relationship in case of Lithuania.
Earnings and unemployment rate in 1998-2009
0 5 10 15 20
Level of unemployment (%)
Figure 3.1. Phillips curve (1) in Lithuania during the period 1998 to 2009
Despite many empirical failures of this type of Phillips curve, it looks reasonably similar to the original relationship found by Phillips in 1959. Only two red dots (which correspond to two pairs of wage inflation and unemployment) are a little bit distant from the trend line (green line). Phillips (1958) used a mathematical expression to generalize
his empirical findings. The latter had a form )(Ufw
, where w is logarithm of money wages (a dot over a variable indicates rate of change of the variable) and U is the level of unemployment. The logic is trivial: the higher shortage of labour we have, the quicker we need to increase its price. The empirical relationship as we can see in figure 3.1 was given a theoretical interpretation by Lipsley (1960). In his model in unemployment was a (negative) proxy for excess demand for labour and wage change responded to excess
demand for labour (Arestis, Sawyer, 2007). Despite further developments made by Friedman (1968) and other researchers, Lipsley’s formulation of the Phillips curve became old-fashioned, although it offered the initial theoretical justification of the model.It is often concluded that there is no firm basis to state that there is a negative relationship between the rate of change of wages and the level of unemployment. This is a fair statement to finish up with this version of the Phillips curve and move to the other, slightly different one. Let’s have a look at different version of the Phillips curve – a relationship between price inflation and unemployment. For this purpose, a figure below is presented.
Inflation and unemployment in 1998-2009
0 5 10 15 20
Level of uneployment (%)
Figure 3.2. Phillips curve (2) in Lithuania during the period 1998 to 2009
Slightly worse, but still a visible fit of the Phillips curve can be seen in figure 3.2. No signs of stagflation (combination of high inflation and high unemployment) like were in 1970s. Samuelson and Solow (1960) contributed a lot in translating the original Phillips curve to this one, which relates the price inflation with unemployment. Equation of this macroeconomic model usually is expressed using the following form
where y is a measure of output gap. Using wage inflation and price inflation as closely related variables basically implies that inflation is an unemployment related issue instead of being related to the product market. However, Arestis and Sawyer (2007) argue that there “is the question of the compatibility of mark-up pricing with the wage inflation Phillips curve”. Their argument is Walras’ law which states that excess demands over the markets equal to zero. Appealing to this law, if we had an excess demand for labour, then we would have an excess supply of output in the product market. Arestis and Sawer (2007) continue: “Positive excess demand for labour with real wages below equilibrium would lead to wages rising faster than prices, and that would be complemented by negative excess demand for output with price/wage ratio above equilibrium and prices tending to fall relative to wages”. In other words, according to Walras’s law, wage inflation and price inflation should not be closely relates. Obviously, this result holds if and only if the Walras’s law holds. However, it is
claimed that Walras’ law is often violated by Keynesian macroeconomic models (Sargent, 1979). This is also one of concerns about the plausibility of Phillips curve if it violates Walras’ law. In addition, Arestis and Sawyer (2007) underlined a few other shortcomings of the Phillips curve as a relationship between price inflation and unemployment, some developments, but they are not under scope of this dissertation. Summing up, they conclude that the excess demand approach relating to the Phillips curve is problematic and does not provide a secure basis for it. Moreover, this approach designed for the presence of perfect competition, when the supply and demand curves are defined. When we have imperfect competition, firms are price makers and by setting their prices these firms eliminate any excess demand. Arestis ans Sawer (2007) says that “under imperfect competition, the level of price (relative to cost) is related (though not monotonically) with output, and hence it appears that the rate of change of price will be related with the rate of change of output under imperfect competition”. But new Keynesian theory has a different view about this. Leaving two above mentioned approaches behind, we now move to the new Keynesian approach.
3.2 The new Phillips Curve and its Shortcomings
Let’s assume that we are going to determine a model in an environment of monopolistically completive firms that face some type of constraints on price adjustment. One of the constraints follows the scenario suggested by Taylor (1980) in his work about the staggered contracts. The constraint is that the price adjustment rule is time dependent. In the spirit of Taylor’s (1980) model, assume that all firms change their prices for N
periods of time. A constant fraction N
1of all firms changes their prices in any given time
period. This example differs from the Taylor’s model in the way that the pricing decision evolves explicitly as a result of profit maximization problem (of monopolistic competitor).Gali and Gerler (2008) remind that such aggregation as defined by Taylor (1980) is indeed a complicated task to do: It is necessary to keep track of the price histories of firms. Thankfully, we can use an assumption originally raised by Calvo(1983) and now commonly used. This assumption simplifies the aggregation problem by a large-scale. The key elements of this assumption from Calvo’s (1983) staggered price model are as follows. In each period some firms change price and others do not. In each period, a fraction of firms do not change their price. To put it differently, in each given period,each firm changes its prices with probability 1 and leaves unchanged with probability . This probability does not depend on the time elapsed since he last price adjustment. According to Gali and Gertler (2000), the expected time when the price
remains fixed equals to
kk . In such way, the parameter provides a
measure of price rigidity. For example, if 75.0 (in a quarterly model), then firms keep their prices fixed on average for a year. By using this approach we greatly simplify the
aggregation problem, because the adjustment probabilities do not depend on firm’s price history.Assume that all firms are identical ex ante. The only differences are that each firm produces a differentiated product and firms have different price histories. In addition, assume that each firma faces a downward sloping constant price elasticity curve (Gali and Gertler, 2000). Then, applying the law of large numbers and log-linearizing the price index around a zero-inflation steady state, it is possible to construct the aggregate price level using a weighted average of lagged price level tp and the optimal reset price (or the
optimal changing price) *tp , as follows
(3.3) *1 )1( ttt ppp
her p denotes the (log) price level and *p denotes (also log) the newly set optimal price.
Considering that all firms are identical (except the differentiate products they produce), at time t a fraction 1 of firms should set their prices at new level *
tp . Appealing to the
law of large numbers, the index of prices of those companies which do not change prices during the period is simply equal to the lagged price level (Gali and Gertler, 2000). It is not difficult to show that profit-maximizing firm will set *
tp according to the following
Where is a subjective discount factor and nktmc is the logarithm of nominal marginal
costs in period t+k of the firm that last time set its price in period t. This approach defines the optimal reset price that is set by profit-maximizing firm, taking into account time dependent pricing rules suggested by Calvo. In the limiting case ( 0 ) we have perfect price flexibility and the firm changes price proportionately to movements in the current marginal cost (Gali and Gertler, 2000). When the degree of price rigidity increases (this degree is measured by ), then the expect time when the price is likely to remain fixed also increases. As a result of this, the firm puts more weight on expected future marginal costs when choosing the current price (Gali et al, 2001). Assuming that inflation at period t can be expressed as 1 ttt pp , the percent
deviation of the firm’s real marginal cost from its steady state value denoting as tmc , and
combining equations (3.3) and (3.4) we can get the following expression:
(3.5) 1 tttt Emc
)1)(1( . Note that the latter depends on the frequency of price
adjustment and subjective discount factor . Rewriting equation (3.5) for next period we get
211 tttt Emc
(3.5a) 322 tttt Emc
433 tttt Emc etc.
Substituting equation (3.5a) into equation (3.5), we obtain that inflation today “corresponds to the expected discounted marginal cost flow” (Melihovs, Zasova, 2007):
Consequently, this means that firms make pricing decisions based on expectations of the future behavior of marginal costs. This conclusion comes intuitively knowing that firms are forward looking, they prices as a markup over a discounted stream of expected future nominal marginal costs, and must lock into price for multiple periods (Gali and Gertler, 1999).According to Gali and Gertler (1999), we can assume that marginal costs are proportional to the output gap (a log-linear relationship exists). In addition, denoting *
ttt yyx as
output gap (where ty and *ty denote the natural logarithms of actual output and potential
output respectively), we can express the marginal cost as a function of tx :
(3.7) tt kxmc
Where k is the output elasticity of marginal costCombining the relationship between marginal cost and the output gap (equation (3.7)) with equation (3.5), we obtain:
(3.8) 1 tttt Ekx
The latter equation shows that the new Phillips curve implies that current inflation depends on output gap and inflation expectations, so it is similar to the traditional Phillips curve. However, unlike the in the standard Phillips curve, )(1 ttE is replaced
by )( 1ttE . That is, “actual inflation is affected by currently expected inflation of next
periods rather than lagged inflation of previous periods” (Melihovs, Zasova, 2007).Despite the new approach, this type of Phillips curve, also known as new Keynesian Phillips curve, faces some shortcomings in theoretical and empirical considerations. Gali and Gertler (1999) emphasizes that the conventional output gap measures may not be particularly reliable due to unobservable rate of natural output *
ty . They argue that despite
various proxies for the potential output *ty , these measures contain significant
measurement error. Another issue mentioned by Gali and Gertler regards the conditions
under which the output gap corresponds to marginal cost. They are concerned if these conditions are satisfied. And if not, structural estimates of the Phillips curve based on the output gap should be treated with caution. Another implication of the NKPC is also underlined by Gali and Gertler (1999). According to them, equation (3.5) implies a negative relationship between the lagged output gap and current change in inflation rate; however, their study with the U.S. data has shown that “the inflation rate depends positively on the lagged output gap rather than negatively: The estimated equation, unfortunately, resembles the old curve rather than the new!” (Gali and Gertler, 1999). Arestis and Sawer (2007) add some more criticism on the NKPC. They argue that although derivation of equation (3.4) is based on the assumption of increasing marginal costs, results from various surveys show that most of the respondents confirm the opposite – declining marginal costs when producing additional units of product. In addition to many more arguments (see paper for details), Arestis and Sawer (2007)conclude that the NKPC based on the output gap lacks theoretical justification.
3.3 The new Keynesian Phillips Curve by Gali and Gertler
After all the criticism presented by different authors regarding the NKPC using the output gap measures, Gali and Gertler (1999) offered a new approach. The idea of their work was to express inflation in terms of an observable measure of aggregate marginal cost. In other words, they estimate equation (3.5) instead of equation (3.8). Gali and Gertler use restrictions from theory to derive a measure based on observable marginal cost. Let’s begin with derivation of real marginal cost measure. One of the simplest measures of marginal cost is one based on the assumption of a Cobb-Douglas technology. Denoting technology with tA , capital with tK , and labour with tN , output tY is given by
(3.9) nktttt NKAY
The ratio of wage rate to marginal product of labour then corresponds to real marginal
cost and is expressed asttt
1. Therefore, given equation (3.9) we have:
NWS is the labor income share. Using lower case letters for denoting the
percent deviations from the steady state we have:
(3.11) tt smc
Combining equations (3.11) and (3.5) we get the following expression for inflation:
(3.12) 1 tttt Es
Where the coefficient is given by
Taking in account that under rational expectations there is no correlation between the error in forecast of 1t and information dated t and earlier, we can derive from equation
(3.14) 0)( 1 ttttt zsE
Where tz denotes a vector of variables dated t and earlier. Equation (3.13) refers to the
orthogonality condition and forms the basis for estimating the model via Generalized Method of Moments (Gali and Gertler, 1999).
4. What will be done next
In fact, I am having some difficulties in the process of estimation, but hopefully I will manage it. Obviously, that’s why I am sending not a full paper.No introduction yet, but it will go lastly. I will also add what has been done by other researchers regarding the Phillips curve in Lithuania. I did not write about the hybrid model, because it might be above my abilities and the main idea of this job is to write a paper which mainly gives basic ideas of what is the Phillips curve and how it became so different in comparison with the original one. In fact, I am doing not very advanced, but rather important job to me and maybe to someone else who will be interested in my native country. That is why I wrote so much about the economic development and all main processes that were in those 20 years of independence. By going this way I managed to distance from simply copying other authors and ideas and giving some simple analysis by myself. Being a student of investment studies, it was dangerous to choose such topic, but now I am happy anyway, despite the mark I am going to get, because I learned interesting about macroeconomics, got familiarized with most important economic figures, etc.
Any comments of yours will be highly appreciated.
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 Friedman, Milton, “The Role of Monetary Policy.” American Economic Review 58, no. 1 (1968): 1–17.
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 Ober-Haus real estate advisors. All information used in the dissertation is available at http://www.ober-haus.lt/news/price-index. Last time accessed at 25/07/2010.
 “IEA: Oil supply crunch and mega-recession by 2013”, available athttp://www.whatmattersweblog.com/2009/03/01/iea-oil-supply-crunch-and-mega-recession-by-2013/. Last accessed at 28/07/2010.
 Tobin, J. “Inflation and Unemployment”, American Economic Review, (1972), 62(1), 1-26
 Samuelson, P. and Solow, R.,‘Analytical aspects of anti-inflation policy’, AmericanEconomic Review, (1960), vol. 50(2), pp. 177-94 Sargent, T.J., Macroeconomic Theory, New York:Academic Press, 1979. Thomas I. Palley, “Walras' Law and Keynesian Macroeconomics”, 1997. Gali J. and Gertler M., “Inflation Dynamics: A Structural Econometric Analysis”, 2000. Gali J., Gertler M., and Lopez-Salido D., “European Inflation Dynamics”, 2001.