Academic journal article Journal of Money, Credit & Banking

Exchange Rate Regimes and Shifts in Inflation Persistence: Does Nothing Else Matter?

Academic journal article Journal of Money, Credit & Banking

Exchange Rate Regimes and Shifts in Inflation Persistence: Does Nothing Else Matter?

Article excerpt

The "Lucas critique" (Lucas 1976) presents a formidable challenge to any remaining adherents of a stable Phillips curve trade-off between inflation and unemployment. Lucas's basic premise is that rational agents' decision rules are regime dependent. A stable Phillips curve trade-off would require that, as we move from a stable-price regime to an inflationary regime, inflation expectations and wage claims continue to evolve in the same old way. Unemployment falls in this case because workers keep expecting prices to revert to their former levels and never seek compensating wage increases.(1) If Lucas is correct, and inflation expectations and wages do adjust to the change in regime, empirical work should be able to link shifts in the Phillips curve with shifts in the economic environment.

A key practical problem in testing the implications of the Lucas critique remains that of isolating the regime shifts that cause agents' decision rules to change. Alogoskoufis and Smith (1991; henceforth A-S) focus on changes in the international monetary standard as phenomena that lead to shifts in the degree of inflation persistence. Such shifts in inflation persistence, in turn, affect the Phillips curve by producing shifts in rational agents' expectations formation and wage bargaining behavior. A-S argue that sharp increases in inflation persistence were accompanied by shifts in U.K. and U.S. Phillips curve trade-offs both in 1914 (as the classical gold standard ended with the onset of World War I) and in 1968 (following the 1967 devaluation of sterling that may have signaled the end of Bretton Woods).

In this paper, we examine the implications of combining allowance for the effects of shifts in the exchange rate regime with the potential role played by other exogenous factors like World Wars I and II (see also Alogoskoufis 1992), central bank reforms, and the two oil price shocks of the 1970s. Our empirical framework builds upon A-S's Phillips curve analysis of the United Kingdom and United States.(2) We combine updated U.K. and U.S. data with further series on Canada and Sweden.(3) Our results offer some support for a shift in inflation persistence around 1914 but appear to contradict the premise that there was a further shift in 1968. We do, however, find more widespread evidence of the role played by the oil price hikes of 1973-1974 and 1979-1980. There appear to be additional shifts in the Canadian and U.K. equations that correspond to changes in domestic monetary institutions.

Our empirical work also draws attention to significant problems with the original A-S equations. The hypothesized inflation process does not adequately fit the data in some instances and there are problems with serial correlation. In our analysis, we modify the inflation and wage equations in the A-S framework to allow for changes in the mean inflation rate over time. We then test for one or more discrete shifts in the inflation process occurring at unknown dates using some recently developed statistical tests. These additional findings corroborate our initial conclusion that the emphasis attached by A-S to a shift in inflation persistence after 1967, in particular, is overstated.

1. METHODOLOGY

We initially estimate the following two preferred equations from A-S (p. 1257). Equation (1) is a price-inflation equation while equation (2) is a wage-based Phillips curve:

(1) [Delta][p.sub.t] = [b.sub.0] + [b.sub.1][Delta][p.sub.t-1] - [e.sub.1t]

(2) [Delta][w.sub.t] = [c.sub.0] + [c.sub.1][Delta][p.sub.t-1] + [c.sub.2][Delta][u.sub.t] + [c.sub.3][u.sub.t-1] + [e.sub.2t]

where [p.sub.t] is the log of the consumer price index, [w.sub.t] is the log of nominal wages, [u.sub.t] is the unemployment rate, [e.sub.it], i = 1, 2 are error terms, and A denotes the difference operator.

A key hypothesis tested by A-S is that, as the persistence of inflation changes under different exchange rate regimes, the coefficient on lagged inflation in both equations (1) and (2) should be significantly affected. …

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