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Wednesday, July 25, 2007

The Phillips Curve In Latvia

The Latvian National Bank have a new working paper out, on guess what, the Philips curve. This is issue is hardly surprising given the labour supply and inflation issues which exist right now. Now aside from a lot of theoretical "hocus pocus" and equations etc, some things of interest do stand out:

Estimation of the Phillips Curve For Latvia

Aleksejs Meļihovs and Anna Zasova

Of late, trend inflation issues are gaining importance in Latvia as well. Nowadays,
with the rate of inflation (including also core inflation) soaring, understanding the
inflation formation mechanism and the reasons of persisting inflationary pressures in
the country is particularly crucial.

The job-seekers ratio to economically active population (from Latvia's labour surveys) has been used as an indicator of unemployment. This indicator reflects the situation in the labour market more accurately than does the registered unemployment rate, because it covers also people who are looking for work on their own and do not apply to the State Employment Agency.......

Model results suggest that around 50% of Latvian companies form adaptive inflation expectations or are backward-looking, whereas the average time between two consecutive price adjustment events is around 6 months. The comparison of the study results with similar outcomes from papers on the euro area and the US enabled the authors to conclude that the behaviour of economic agents in Latvia is notably different. First, companies with rational expectations or those that are forwardlooking prevail in both the euro area and the US. Second, the expected time for prices to remain constant in Latvia is considerably shorter than in the euro area (3 years) and the US (1.5 years).

In Latvia, inflation expectations are an important factor affecting the actual inflation rate. Moreover, quite frequent output price adjustments in Latvia imply that changes in inflation expectations would relatively soon pass through to actual prices in Latvia. Model results suggest that around a half of all Latvian companies are forward-looking, implying that they are forming their inflation expectations on the basis of information about those economic fundamentals that may have implications for price changes in the future. It leads to an inference that timely and broadly-based information about the expected inflation dynamics and changes in it supplied to the companies would lower inflation expectations and, consequently, also the actual inflation rate. Simultaneously, the comparatively large number of companies with adaptive inflation expectations in Latvia adds to the persistence of overall inflation expectations in the country and renders the task of reducing inflation expectations more complicated.

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