Inflation Differentials Research Articles

Vesicular komatiites, 3.5-Ga Komati Formation, Barberton Greenstone Belt, South Africa: inflation of submarine lavas and origin of spinifex zones

Komatiites of the 3.5-Ga Komati Formation are ultramafic lavas (>23% MgO) erupted in a submarine, lava plain environment. Newly discovered vesicular komatiites have vesicular upper crusts disrupted by synvolcanic structures that are similar to inflation-related structures of modern lava flows. Detailed outcrop maps reveal flows with upper vesicular zones, 2–15 m thick, which were (1) rotated by differential inflation, (2) intruded by dikes from the interior of the flow, (3) extended, forming a flooded graben, and/or (4) entirely engulfed. The largest inflated structure is a tumulus with 20 m of surface relief, which was covered by a compound flow unit of spinifex flow lobes. The lava that inflated and rotated the upper vesicular crust did not vesiculate, but crystallized as a thick spinifex zone with fist-size skeletal olivine. Instead of representing rapidly cooled lava, the spinifex zone cooled slowly beneath an insulating upper crust during inflation. Overpressure of the inflating lava may have inhibited vesiculation. This work describes the oldest vesicular komatiites known, illustrates the first field evidence for inflated structures in komatiite flows, proposes a new factor in the development of spinifex zones, and concludes that the inflation model is useful for understanding the evolution of komatiite submarine flow fields.

Price Level Convergence, Relative Prices, and Inflation in Europe

If price levels are initially different across the euro area, convergence to a common level of prices would imply that inflation will be higher in countries where prices are initially low. Price level convergence thus provides a potential explanation for recent cross-country differences in European inflation, a worrisome development under the ECBs one-size-fits-all monetary policy. I present direct evidence on price level convergence in Europe, using a unique data set, and then investigate how much of the recent divergence of national inflation rates can be explained by price level convergence. I show that between 1990 and 1999 prices did become less dispersed in the euro area. Convergence is especially evident for traded goods, and more in the first half of the 1990s than the second half. By some measures, traded goods price dispersion across the euro area is now close to that across U.S. cities. Despite an on-going process of convergence, deviations from the law of one price are large. Finally, I find a statistically-significant and robust negative relationship between the 1999 price level and 2000 inflation rate in Europe, and that the contribution of price level convergence to explaining inflation differentials is often quite important economically. Still, factors other than price convergence explain most of the cross-country inflation differences.

Price Level Convergence, Relative Prices, and Inflation in Europe

If price levels are initially different across the euro area, convergence to a common level of prices would imply that inflation will be higher in countries where prices are initially low. Price level convergence thus provides a potential explanation for recent cross-country differences in European inflation, a worrisome development under the ECBs "one-size-fits-all" monetary policy. I present direct evidence on price level convergence in Europe, using a unique data set, and then investigate how much of the recent divergence of national inflation rates can be explained by price level convergence. I show that between 1990 and 1999 prices did become less dispersed in the euro area. Convergence is especially evident for traded goods, and more in the first half of the 1990s than the second half. By some measures, traded goods price dispersion across the euro area is now close to that across U.S. cities. Despite an on-going process of convergence, deviations from the law of one price are large. Finally, I find a statistically-significant and robust negative relationship between the 1999 price level and 2000 inflation rate in Europe, and that the contribution of price level convergence to explaining inflation differentials is often quite important economically. Still, factors other than price convergence explain most of the cross-country inflation differences.

A framework for stabilizing the euro/yen/dollar triplet

The current debate on exchange rate regimes is shaped by the so-called inconsistency triangle. In this paper I show that the discussion has overlooked a “third way” which combines capital mobility with monetary policy autonomy, and an exchange rate path determined by interest rate differentials. My scheme relies on interventions that are always carried out by the central bank with the strong currency, and a full sterilization of interventions with the instrument of a deposit facility. Thus the G3 central banks could set a band for their bilateral exchange rates with the floor and the ceiling defended by the respective strong central bank. As exchange rates bands are adjusted according to short-term interest rate differentials, there are no sterilization costs for the intervening central bank. Over the medium and long run interest rates are mainly determined by inflation differentials. Thus, the exchange rate band would follow a PPP path.

Expenditure on the NHS in Perspective

In the wake of the recently-announced increases in health spending, Martin Chalkley reviews the record of health spending in the UK both historically and comparatively. It is clear that prices paid by the NHS have increased more than prices in general, and once this is allowed for then it appears that real health spending today is only twice that of 50 years ago as compared with the fourfold increase suggested when using a general price deflator. Such differential inflation is obviously not a problem which is confined to the UK, and it does add considerably to problems in making proper comparisons between levels of health spending in different countries. In spite of these difficulties, it seems that compared with many other developed countries, health spending in the UK as a proportion of GDP is modest. So, looking ahead, there is some way to go before the UK attains the levels of spending achieved in many other countries. But understanding the reasons for relative price changes is vital if any proposed increases in spending is to be translated into increases in the quantity and quality of services provided.

The Aftermath of Appreciations

This paper empirically analyzes a broad range of real exchange rate appreciation episodes. The objective is twofold. First, the paper studies the dynamics of appreciations, using a sample that is not limited to cases that end in crisis (or devaluation). Second, the paper analyzes the mechanism by which overvaluations are corrected. In particular, for various degrees of misalignment we calculate the proportion of the reversions that occur through nominal devaluations rather than through cumulative inflation differentials. The overall conclusion is that in most cases large and medium appreciations are reversed with nominal devaluations.

Term structure and interest differentials as predictors of future inflation changes and inflation differentials

The paper tests the unbiasedness of interest differentials and term structure as predictors of inflation differentials and inflation changes, respectively, using three-, six- and twelve-month maturities in eight major industrial countries over the period 1981–1992. The first hypothesis requires rational expectations (RE) and equality of ex-ante real interest rates, which in turn holds only in the presence of uncovered interest parity (UIP) and ex-ante purchasing power parity (PPP). The second is correct if, in addition to RE, the Fisher hypothesis and constancy of ex-ante real rates are satisfied. The empirical results lead to the rejection of both null hypotheses, although interest differentials and term structure do appear to be relatively useful for forecasting purposes. In particular, the interest differential model performs better than simple ARMA models at the shortest end of the maturity spectrum in out-of-sample forecasting.

Rational expectations, inflation and the nominal interest rate

There is a substantial empirical literature, beginning with Fama (1975), that utilizes regressions of the inflation rate in a given period on initial interest rates (or inflation differentials on the slope of the initial yield curve) to test the Fisher hypothesis and/or to provide forecasts of inflation. Both uses depend critically on the maintained hypothesis that asset market prices fully incorporate all relevant current information about future yields. This paper will investigate the plausibility of the rational expectations hypothesis for real returns in markets for one-period default-free bonds, will show that under normal macroeconomic assumptions it cannot be expected to hold, and will consider the consequences of its failure for the interpretation of empirical results.

Measuring exchange rate misalignment: Inflation differentials and domestic relative prices

Empirical studies of exchange rate misalignment generally use crosscountry differences in overall inflation as proxy measures for a country's real exchange rate (RER). This paper shows that using such differential-inflation proxies introduces two systematic biases in model results: understatement of RER movements; and a spurious trend towards depreciation. These biases can be corrected only with disaggregated data on domestic relative prices of tradable and nontradable products. Using a standard model with disaggregated data for Zimbabwe, it is found that proxy-based results understate misalignment by almost 25% and exaggerate depreciation by 4% per year.

Target Zones and Realignment Risk: An Integrated Approach

In this paper, it is shown that inflation differentials and trade deficits were significant determinants for exchange rate movements in the European monetary system. Since the target zone prevents EMS exchange rates from adjusting gradually to changing economic conditions, a standard regression model cannot detect this influence however. Therefore, a new econometric model is introduced, in which deteriorating competitiveness increases the probability of large depreciations and high volatility. These depreciations can be due to large devaluations or to panic reactions of the market due to expected devaluations. It is shown that the out-of-sample predictions of the model outperform the random walk, and that large arbitrage gains can be made in the foreign exchange market if our model predictions are used.

Is Price Inflation Different for the Elderly? An Empirical Analysis of Prescription Drugs

Recently controversy has surrounded the issue of whether Social Security payments to the elderly should continue to be adjusted automatically according to changes in the Consumer Price Index (CPI). One issue in the public policy debate concerns whether price inflation is different for the elderly, particularly because the official Bureau of Labor Statistics price indexes for medical care have been growing more rapidly than the overall CPI, and medical care expenditures constitute a larger proportion of the elderly’s budget than of the young’s.Using annual IMS data from 1990 to 1996, we examine empirically whether elderly-nonelderly price inflation differentials exist for prescription pharmaceuticals. We assess prices for prescription drugs destined for ultimate use by the elderly versus the nonelderly at three points in the distribution chain: initial sales from manufacturers, intermediate purchases by retail pharmacies, and final sales from retail pharmacies to patients or payors. We find that at the initial point in the distribution chain, no differences in price inflation exist for the aggregate of drugs destined for use by the elderly versus those for the nonelderly. At the intermediate sell-in point to pharmacy distribution, we examine antibiotics (ABs), antidepressants (ADs), and calcium channel blockers (CCBs). For ABs, since 1992 price inflation has been somewhat greater for the elderly than for the young, reflecting in part the elderly’s more intensive use of newer branded products having fewer side effects, adverse drug interactions and more convenient dosing—attributes of particular importance to the elderly. For ADs, price inoation is considerably less for the elderly than for the young, due in large part to the elderly’s greater use of older generic products. For CCBs, elderly-nonelderly differentials are negligible. None of these differentials adjust for variations in quality.At the final retail sell-out point, we examine only ADs. We find that because retailers obtain larger gross margins on generic than on branded products, and because the elderly are disproportionately large users of generic ADs, the elderly-nonelderly price inflation differential benefiting the elderly at the intermediate point is reduced considerably at final sale.

The Demise of the High Inflation Trade-Off Interpretation A Reply to Chapple

Two pieces of historical evidence have forced a re-evaluation of the textbook story about Phillips’ contribution to stabilisation policy. The first is the realisation that there existed, prior to Lucas (1976), a ‘Phillips Critique ’; the second is that Friedman used what is now called “Phillips ’ Adaptive Inflationary Expectations Formula” to undermine the high inflation Phillips Curve. In a subsequent paper, I shall argue that Phillips constructed his econometric policy evaluation critique in three stages. The first stage (1950–62) involved work on the curve that bears his name; the second (1967–8) and third (1972) were of more general applicability. The first stage took zero or trivial inflation plus exogenous import prices as part of the ‘structure’ of his model; a regime shift to a non-trivial inflation outcome changed the ‘structure’ of his model. In particular, an inflation-devaluation spiral (caused by quite small inflation differentials) would, via rising (and now endogenous) import prices, set offa “wage-price spiral” thus displacing Phillips curve observations off to the right in a stagflationary direction. In the present paper, I shall demonstrates that Chapple has unwittingly surrendered his position about the stable trade-off in Phillips’ work: when inflation generates the expectation of a continuation of inflation this, in Phillips’ model, increases inflation still further, thus destroying the notion of a “stable” tradeoff. But the instability caused by inflation in Phillips’ model is far removed from the cosy equilibrium forces of the conventional natural-rate model. Thus Chapple’s defence of the textbook story tell us more about the reliance on textbooks as the transmitter of ‘authoritative analysis’ than it does about Phillips’ subtle and insightful stabilisation proposals.

Credibility and Disinflation in the European Monetary System

Analysis of interest differentials in the European Monetary System has suggested a widespread lack of credibility of the Exchange Rate Mechanism in the sense that in most countries the implicit expected rate of devaluation was significant and not far short of inflation differentials vis-a-vis the deutschmark. We present and test a model in which prices reflect expectations of exchange rate behaviour. The results provide mixed evidence that price-setting in countries which participated in the ERM was influenced by the exchange rate discipline.

Credibility and Disinflation in the European Monetary System

Analysis of interest differentials in the European Monetary System has suggested a widespread lack or credibility of the Exchange Rate Mechanism (ERM) in the sense that in most countries the implicit expected rate of devaluation was significant and not far short of inflation differentials vis-a-vis the deutschmark. The authors present and test a model in which prices reflect expectations of exchange rate behavior. The results provide mixed evidence that price-setting in countries that participated in the ERM was influenced by the exchange rate discipline. Copyright 1997 by Royal Economic Society. (This abstract was borrowed from another version of this item.)

Tests of three parity conditions: Distinguishing risk premia and systematic forecast errors

This study provides evidence that uncovered interest differentials between currencies cannot be attributed to either risk premia or systematic forecast errors alone. The evidence is based on developing joint tests of three parity conditions: uncovered interest parity, purchasing power parity, and real interest parity. The study tests parameter restrictions based on knowing that risk premiums only affect nominal and real interest differentials, but not inflation differentials, while systematic errors in forecasting exchange rates only affect nominal interest differentials and inflation differentials, but not real interest differentials. The study finds a variety of cases where deviations from some or all of the parity conditions can be systematically related to variables currently known to investors and borrowers. The most intriguing evidence is that for some currencies, these deviations from parity are perfectly correlated as if they were driven by a common factor.

Inflation differentials and excess returns in the European Monetary System

The dynamics of weekly excess returns of an investment in a foreign currency against that in the D-Mark are studied for four EMS currencies. For most of the period 1979–1990, the interest differentials within the EMS have been higher than the realized depreciations relative to the D-Mark. Two explanations for the existence of excess returns are found. The first is uncertainty, measured by the conditional standard deviation, which is influenced to a large extent by the inflation differential. The second source is the continuously changing perceived realignment risk, which causes the returns to be negatively correlated and induces a positive relationship between the returns and the position of the spot rate in the fluctuation band.

Likelihood versus timing of speculative attacks: A case study of Mexico

This paper estimates a survival model to identify the role of macroeconomic fundamentals on the likelihood and the timing of a currency crisis for Mexico during 1982–1994. Foreign reserve losses, expansionary output, expansionary monetary and fiscal policies, an increase in inflation differentials, and an appreciation of the real exchange rate appear to have contributed to the speculative pressures. On the other hand, the decline in foreign reserves and the increase in the share of short-term foreign currency-indexed debt seem to be the main factors which determined the timing of speculative attacks.

Multi-country evidence on the behavior of purchasing power parity under the current float

Using panel data for the United States and 22 other OECD countries for the current float, this paper presents evidence that despite substantial short-term perturbations, purchasing power parity actually performed much better than commonly believed. Average rates of growth of real exchange rates over long horizons bear little relationship either to average rates of growth of nominal exchange rates or to average inflation differentials, thus implying a close to one-to-one relation between average rates of growth of nominal exchange rates and average inflation differentials. Panel-data variants of standard unit-root tests suggest that the real exchange rates of these countries can be characterized as mean-reverting.

Evaluating the EMU Criteria: Theoretical Constructs, Member Compliance and Empirical Testing

European Monetary Union requires EU members to fulfill five criteria. Theoretical support for these five criteria is weak and empirical tests have not been attempted. This study reviews the theory, investigates the extent to which EU members meet the requirements and tests the criteria empirically. It assesses whether the EMU criteria are indicators for exchange rate stability. The best results obtained suggest, that the debt criterion has no role to play and that high inflation differentials and high budget deficit/GDP ratios are more consistent with exchange rate stability. Therefore the empirical results confirm the theoretical weakness of the criteria to a fixed exchange rate or a single currency. Copyright 1997 by WWZ and Helbing & Lichtenhahn Verlag AG

Testing for Unbiasedness of Term Structure and Interest Differentials As Predictors of Future Inflation Changes and Inflation Differentials

This paper argues that the unbiasedness of interest differentials as predictors of future inflation differentials and of the term structure as a predictor of future inflation changes are independent propositions. The first requires rational expectations (RE) and equality of ex-ante real interest rates, which holds only in the presence of uncovered interest parity (UIP) and ex-ante purchasing power parity (PPP). The second is correct if, in addition to RE, the Fisher hypothesis and co:nstancy of ex-ante real rates are satisfied. The issue of the information contained in the term structure of interest rates is important because if the relationship between interest rates for different maturities could help predict future inflation the yield curve could be a guide for monetary policy. Fama's (1975) seminal paper found that real interest rates are constant over time, with fluctuations in nominal rates mainly reflecting changes in expected inflation (the so-called Fisher effect). On the contrary, Mishkin (1984a) rejected the constancy of real rates and the existence of a Fisher effect in a number of OECD countries. As for the hypothesis that interest differentials are unbiased predictors of future inflation differentials, it is of interest for two main reasons. First, the equality of real rates which is implied would mean that monetary policy is not an effective stabilization tool in an open economy as real economic activity could not be influenced through the real interest rate. Second, real interest rate equalization across countries requires that UIP and PPP be satisfied. Therefore it is a test of the monetary approach to exchange rates versus models which depend on real rates differing between countries in the short run. Amongst previous researchers, Mishkin (1984b) could not reject the equality hypothesis in bilateral tests of the US vis-a-vis six industrialized