Abstract
An application of New Keynesian models to inflation in Croatia Background: The inflation dynamics of Croatia is studied in the paper, with the review of applicable marginal cost proxies for the hybrid New Keynesian Phillips Curve (NKPC), and estimation of three specifications of the hybrid NKPC for Croatia. Objectives: The goal of this research is to examine the effect of labor's share of income, the price of energy, and the price of imports and other open economy factors in driving inflation in Croatia from the first quarter of 2000 to the fourth quarter of 2011. Methods/Approach: We use the generalized method of moments (GMM) estimator to empirically estimate three NKPC specifications. The J-stat and Cragg-Donald F-test are used to test for overidentification and for weak instruments, respectively. Results: We find that the marginal cost proxy for the energy-augmented specification is statistically significant and quantitatively the largest, whereas those for the other two are statistically significant, but quantitatively negligible. Conclusions: The results provide an empirical contribution both to the literature on inflation in Croatia and the literature of the NKPC in a small open economy. We can conclude that the price of energy has been the strongest driver of inflation, whereas the open economy factors we tested have had very little influence.
Highlights
The modelling of inflation in the short run is an area of macroeconomics where answers are both urgently needed yet difficult to obtain
It is inadequate for a small open economy, where including the cost of imported materials is necessary; it fails to take into account labor market frictions and materials prices; and in the interest of simplicity, it disregards the costs of capital investment
We discuss two recent efforts to construct an improved proxy, and consider their adaptation for a small open economy model that would be useful in Croatian inflation research
Summary
The modelling of inflation in the short run is an area of macroeconomics where answers are both urgently needed yet difficult to obtain They are urgently needed because accurate forecasts of short-run inflation are vital for effective monetary policy; there are as yet no forecast methods that perform reliably in all situations. Phillips curve forecasts (in their current form, i.e. those forecasts that rely on a real activity variable such as unemployment, the output gap, or real marginal costs) appear to achieve better results than any other currently used method (Stock and Watson, 2008). Having evolved from A.W. Phillips’ relation of unemployment to inflation, the NKPC, in the form it takes today, relates a real activity such as the output gap or real marginal cost to inflation. We can conclude that the price of energy has been the strongest driver of inflation, whereas the open economy factors we tested have had very little influence
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