Structural Changes in Inflation
Abstract: The declining inflation experienced during the last decade is a common feature of both the Euro Area and other developed economies. Possible explanations have been the event of exogenous shocks, such as oil price, effictive exchange rates, and import prices. An increased globalization, leading to an increased competition in both domestic and international markets, eroding firms’ pricing power. For the United States, productivity growth, raising the rate at which the economy can grow without giving rise to inflationary pressures, has also been considered. Yet, the absence of evidence about productivity and competition improvements in the Euro area raises doubts on the validity of such views.
This project is aiming at studying the decline in inflation experienced in Europe during the last decades has raised the issue of the structural change hypothesis in such a process. I relied on structural break analysis, to assess for the changes witnessed by inflation from the seventies onward. The wage and pice inflation equations are estimated over the whole sample period, and instability is being tracked through a battery of structural break tests.
We find that the Phillips curve has been modified since 1981. From 1981 onwards, price inflation seems to have been more inertial than it was in the past. On the wage side, labor productivity, as well as unemployment gap appear to have played an ever-decreasing role in the wage inflation process. Both results tend to confirm a structural change in the standard Phillips curve. The classic trade-off existing between unemployment and wage inflation seems if not to have disappeared, yet to have significantly diminished over the past two decades.
When considering possible cause of changes in the inflationary process, it seems that trade liberalization has played no role in the lower inflation experienced within the Euro zone. On the contrary, labor market liberalization witnessed in Europe since the mid-eighties would explain some of the decrease of wage inflation.