Sman , Da id J. C.; Melge , Je oen
A icle
Mone a y and Non-Mone a y Analyses o In la ion in a
Small Open Coun y
K edi und Kapi al
P o ided in Coope a ion wi h:
Duncke & Humblo , Be lin
Sugges ed Ci a ion: Sman , Da id J. C.; Melge , Je oen (1997) : Mone a y and Non-Mone a y Analyses
o In la ion in a Small Open Coun y, K edi und Kapi al, ISSN 0023-4591, Duncke & Humblo ,
Be lin, Vol. 30, Iss. 1, pp. 52-80,
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Mone a y and Non-Mone a y Analyses o In la ion
in a Small Open Coun y*
By Da id J. C. Sman and Je oen Melge , Ro e dam
I. In oduc ion
The issues o in la ion and p ice s abili y p o ide a ecu en opic o
a icles n he popula and scien i ic p ess. Since he dis u bing expe i-
ence wi h seemingly un-away in la ion in he mid and la e 1970s he
main hemes ha e been he desi abili y o p ice s abili y and ea ly wa n-
ings agains (pe cei ed) in la iona y de elopmen s. Th ee ecen a icles
illus a e he na u e o he deba e on in la ion in he Ne he lands. Fo
example, Be ndsen (1993) called o a es uc u ing o wage nego ia ions
as an essen ial pa o a s a egy o main ain p ice s abili y Be k (1994)
sugges ed ha in o de o main ain p ice s abili y, he Du ch go e nmen
should limi i s own con ibu ion o in la ion; i.e. compensa e inc eases
in go e nmen con olled ene gy p ices, housing en s and p ices o
public sec o se ices wi h educ ions in indi ec axes. Be k and Winde
(1994) examined he coin eg a ion o Du ch and Ge man consume
p ices. They conclude ha "a p ice shock in The Ne he lands is e en-
ually adjus ed, in so a as i de ia es om ha in Ge many" (p. 72).
Thei esul s migh sugges ha we can somehow blame in la ion on o -
eign in luences.
Almos e e y s uden in mone a y economics is augh he long-held
consensus iew ha in la ion - p ope ly de ined as he long un upwa d
d i o he gene al p ice le el - is p ima ily a mone a y phenomenon.
We immedia ely add ha his does no mean ha e en in he sho e m
e e y change in p ices is o needs o be caused by a change in he supply
o money Howe e , mac oeconomic heo y and he empi ical e idence
show ha a long- un d i o he gene al p ice le el canno occu wi h-
ou accommoda ion by he mone a y au ho i ies.
* We hank Edua d Bomho , Clemens Kool, Caspe de V ies and a e e ee o
hei aluable commen s and sugges ions. The usual ca ea s apply.
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Mone a y and Non-Mone a y Analyses o In la ion 53
I is puzzling, he e o e, o obse e ha economis s equen ly en e
he public deba e wi h only mino e e ence o he basic mone a y
aspec s o in la ion. We ake his o mean ha one o he h ee ollowing
cases mus be ue: (1) The e me ely exis s a con usion abou he de ini-
ion o in la ion. Whe eas we emphasize he long- un, secula na u e o
p ice changes, o he au ho s equen ly use he e m "in la ion" o all
changes in he gene al p ice index. We ag ee ha in he sho - un
changes in he le el o he gene al p ice index can be aced o a wide
ange o ini ial dis u bances. These do no , howe e , cons i u e a heo y
o in la ion. (2) The e may exis a undamen al disag eemen abou
mac oeconomic heo y and e idence. Some au ho s ejec he mone a y
app oach o in la ion. Fo example, pos -Keynesian economics p o ides
an en i ely di e en app oach, because i is assumed ha mone a y
au ho i ies ha e absolu ely no con ol o e he money supply. This
emains, howe e , a mino i y iew among economis s. (3) Because he
Ne he lands ep esen s a small open economy ha ope a es wi hin a
ixed exchange a e egime, o he au ho s may ha e concluded ha he
mone a y app oach is an inapp op ia e amewo k o policy analysis.
A e all, does he s anda d IS-LM ype model no sugges ha wi h
ixed exchange a es he domes ic money supply and in la ion a e e ec-
i ely unde he con ol o o eign cen al banks?
This pape ( e)e alua es mone a y and non-mone a y in la ion models
o he Ne he lands. In pa icula , we examine whe he a P-s a model -
ep esen ing a ex book mac oeconomic ela ionship be ween money and
p ices - should be ejec ed in a ou o a popula socio-poli ical model
based on cos -push ac o s. In sec ion 2 we de elop and discuss bo h
models. We a gue ha he P-s a model can be used o a small economy
wi h ixed exchange a es and conclude ha he P-s a model need no
be ejec ed on heo e ical g ounds. Sec ion 3 p esen s he empi ical
esul s. We show ha based on in-sample i and ou -o -sample o ecas -
ing he mone a y model is no ou pe o med by he socio-poli ical model.
Thus, he P-s a model need no be ejec ed on empi ical g ounds. Sec-
ion 4 con ains ou concluding ema ks. Basic mone a y economics sug-
ges s ha we should p e e he mone a y in la ion model. We conclude
wi h some obse a ions on he poli ical-economy aspec s o he public
deba e on in la ion and i s de e minan s. I is ou hope ha a simple
illus a ion o some s ylized ac s o mac oeconomics will endo se hei
p ope use in he public deba e abou in la ion.
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54 Da id J. C. Sman and Je oen Melge
13. P-S a and Socio-Poli ical Models o In la ion
1. The P-S a Model
The P-s a model ha has ecen ly been ( e)in oduced by Hallman,
Po e and Small (HPS, 1989) elies on wo undamen al concep s: (1) a
long- un iew o he equa ion o exchange M.V = PQ, and (2) he lagged
adjus men o p ices o hei long- un equilib ium le el. The equa ion o
exchange s a es ha he gene al p ice le el P equals he p oduc o
money pe uni o eal ou pu M/Q and he eloci y o money V. In he
long un, ou pu is assumed o equal he economy's po en ial o end
ou pu Q*. Fu he mo e, in he long un, he equilib ium alue o elo-
ci y V* is assumed o be independen o po en ial ou pu and he money
s ock ( hough no necessa ily independen o i s a e o change). The
ac ual p ice le el will adjus owa d a alue consis en wi h he money
s ock.1
HPS (1989, 1991) de ine he long- un equilib ium o he p ice le el a
ime as he p ice le el ha is consis en wi h he cu en alue o he
money s ock and he cu en equilib ium alues o eloci y and ou pu .
We de i e wo equa ions: one o he ac ual p ice le el P and one o he
equilib ium alue P*
(1) P = m + - q
(2) p* = m +
*
-
q*
whe e lowe -case a iables p, m, and q deno e he loga i hms o he
p ice le el, money, eloci y and eal ou pu . Assume ha he ac ual p ice
le el adjus s owa ds i s long un le el a a cons an a e o adjus men .
In addi ion, because heo y does no p o ide ull insigh in o he
dynamics o he equilib ium mechanism, also assume ha he a e o
p ice change Ap depends on pas changes Ap _i. We de i e he gene al
dynamic equa ion (a > 0)
n
(3) Ap = —a(p -i - p;_i) + Ap -i
i= 1
HPS (1989) applied he P-s a app oach o he U.S. and concluded
ha 'O e pe iods o one yea o longe , he model acks in la iona y
i Humph ey (1989) shows ha he P-s a model is ce ainly no a new model,
bu can be aced as a as he ea ly quan i y heo is s, o example Da id Hume
(1711-76).
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Mone a y and Non-Mone a y Analyses o In la ion 55
de elopmen s a he well despi e hese s ong assump ions; o e sho e
pe iods, ac o s ou side he model play an impo an ole.' (p. 2) Subse-
quen ly, he model has also been empi ically es ed o o he coun ies
( o example, Hoelle and Po e , 1991; Kole and Leahy, 1991; Tod e and
Reime s, 1994; G oene eld, Koedijk and Kool, 1995), gene ally wi h posi-
i e esul s.
So a , de i a ion o he gene al model seemed s aigh o wa d enough
and i mly based on mone a y heo y. Howe e , we mus add ess some
possibly c i ical elemen s in he s anda d P-s a model.
a) Dynamic Speci ica ion
HPS examined he p ocess o p ice adjus men in some de ail and con-
cluded ha a speci ica ion using second di e ences o he p ice le el, o
i s di e ences o he a e o change, i.e. A2p , is app op ia e o he
Uni ed S a es. The use o second di e ences o he p ice le el may ci -
cum en econome ic p oblems associa ed wi h possible nons a iona i y
o in la ion. On he o he hand, some au ho s ha e c i icized he second-
di e ence speci ica ion because i esul s in implausibly long pe iods o
p ice adjus men and implausible o e shoo ing o cyclical beha iou o
p ice changes (Ta om, 1990; Pecchinino and Rasche, 1990).2 Simula ions
by HPS (1989) showed ha in some cases a shock o he sys em equi ed
adjus men pe iods o mo e han 100 yea s. Recen analyses sugges ha
he p oblema ic speci ica ion in second di e ences is no an una oidable
componen o he P-s a model. Fi s , ou iew on (non)s a iona i y o
in la ion is no obus o changes in he sample pe iod. Fo example, i is
highly imp obable ha 100 o 150 yea s o U.S. in la ion da a would
e u n a e dic o nons a iona i y. On he o he hand, in la ion would
exhibi e y s ong nons a iona i y i he sample pe iod is domina ed by
obse a ions om he 1970s. A second conside a ion is ha by now uni -
oo es s o nons a iona i y a e known o be o e y low powe in small
samples ( o example, see McCallum, 1993). I has become common p ac-
ice o i no igno e he o mal econome ic esul s om uni - oo es s,
hen a leas quali y he esul s wi h p ope economic insigh . (We ind
ha a le el speci ica ion o in la ion is adequa e o he Ne he lands in
he sample pe iod we use.)
2 Exac ly wha ime pe iod cons i u es an implausibly long adjus men pe iod is
open o deba e. Empi ical e idence o pu chasing powe pa i y indica es ha
ce ain p ice adjus men s can ake decades.
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56 Da id J. C. Sman and Je oen Melge
b) In la ion Expec a ions
Ano he c i ical issue is he implici ea men o expec a ions in he
p oposed adjus men p ocess. Since he F iedman-Phelps c i ique on a-
di ional Phillips cu es, ex book models o p ice beha iou assume ha
p ice changes consis o expec ed in la ion, plus a e m cap u ing unan i-
cipa ed shocks o p ice disequilib ium leading o subsequen upda ing o
u u e expec ed in la ion. The expec a ions-augmen ed Phillips cu e
would be
(4) A p = A p + Az _i
whe e z usually deno es some measu e o excess demand.
P ice-adjus men models based only on lagged alues o p ice changes
and he lagged p ice gap (p -i - pj_i) can apidly con lic wi h he
hypo hesis o a ional expec a ions (a leas in i s no mal ex book in e -
p e a ion). The adap i e-expec a ions mechanism used implici ly by HPS
is op imal only o speci ic, s a iona y ARIMA p ocesses (classical e e -
ence is Mu h, 1960).
The s anda d P-s a speci ica ion migh a guably be mos sui able o
he case whe e he m, and q ime-se ies p ocesses a e pu e andom
walks ( andom walks wi hou d i ). I is doub ul whe he his is in ac
an accu a e desc ip ion. I i is no , a ional expec a ions imply ha
p ices adjus o no ions o u u e alues o M, V*, and Q* a he han
only he cu en alues o M, V*, and Q*. An al e na i e o mula ion o
he model would hen be (compa e also Tod e and Reime s, 1994)
(5) Ap = Ap - a{p .i - pJ_J
(6) A pi = /(Am +i, A * +i, A q* +i,...)
whe e he expec a ions o unde lying in la ion Ap* depend on expec a-
ions o u u e money g ow h, u u e changes in eloci y and u u e
changes in po en ial ou pu .
Se aside o a momen he ex book in e p e a ion o he a ional
expec a ions hypo hesis, i.e. "pe ec o esigh wi h andom expec a ion
e o ". Lagged adjus men p ocesses can be ully consis en wi h a ional
economic beha iou i , o example, agen s a e con on ed wi h unda-
men al unce ain y abou he pas , cu en , and u u e s a e o he econ-
omy. I is a basic ac ha bo h p o essional economis s and p i a e
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Mone a y and Non-Mone a y Analyses o In la ion 57
agen s ha e only limi ed in o ma ion abou he ela i e impo ance o
nominal e sus eal and empo a y e sus pe manen shocks. Economis s
can also s ongly disag ee on app op ia e mac oeconomic models. This
unce ain y mus a ec he op imal esponse o new in o ma ion ( o a
mo e ho ough exposi ion o his line o easoning see o example, Mel -
ze y 1982; B unne and Mel ze , 1993; and also Mussa, 1975). Lagged
adjus men may simply cap u e an una oidable p ocess o g adual lea n-
ing abou he ac ual impo ance o pas e en s.3
c) Small Open Economies wi h Fixed Exchange Ra es
One migh a gue ha he P-s a model canno be applied o small open
economies whe e he mone a y au ho i ies choose o main ain a ixed
exchange a e. In he P-s a model he gene al p ice le el adjus s
owa ds a le el consis en wi h a pa icula money s ock. Howe e , ex -
book IS-LM models sugges ha wi h ixed exchange a es he money
supply becomes endogenous and is no longe a ailable as an independen
ins umen o mone a y policy. Money ollows a he han causes p ice
changes. Domes ic p ices a e p ede e mined by o eign p ices, he ixed
exchange a e, and he law o one p ice' inco po a ed in pu chasing
powe pa i y (equa ion 7); he in e es a e is ixed by he o eign in e -
es a e h ough (unco e ed) in e es a e pa i y (equa ion 8); and,
because he economy ends o luc ua e andomly a ound i s na u al
a e, he money supply mus au oma ically ollow he demand o money
(equa ion 9: income elas ici y is uni y and c is he in e cep o he equa-
ion).
(7) P =p{ + e
(8) i = i{ + E (Ae +i), wi h £ (Ae +1) = 0
(9) m - p = c + q - 9i
Kool and Ta om (1994) de eloped a P-s a model o small open econo-
mies wi h ixed exchange a es. They a gue ha wi h ixed exchange
a es he equilib ium alue P* should be de i ed om a dominan la ge
3 No e ha his in e p e a ion o lagged adjus men s sugges s ha he adjus -
men p ocess is uns able. The op imal speed o adjus men is linked o he deg ee
o unce ain y abou he economic en i onmen .
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58 Da id J. C. Sman and Je oen Melge
coun y in he exchange a e sys em ( o example, Ge many wi hin he
EMS). Thei esul s indica e ha a o eign-based p ice gap can indeed
ou pe o m he pu ely domes ic p ice gap in he P-s a model.
We accep ha a c edible ixed exchange a e mus ac as a long- un
cons ain on money and p ices. Bu , we a gue ha he e is no eason o
disca d he P-s a model wi h a domes ic p ice gap as a possible desc ip-
ion o p ice le el dynamics. Basically, we dispu e ha in his case he
ex book IS-LM model wi h only a single in e es a e and pe ec in e-
g a ion be ween all goods and inancial ma ke s is a ele an model.
The e a e wo main poin s o c i icism. Fi s , i is a well-known empi i-
cal esul ha pu chasing powe pa i y is no a good desc ip ion o
sho - e m p ice beha iou . Pu chasing powe pa i y can only be es ab-
lished as a long- un phenomenon (see F oo and Rogo , 1994). The e o e,
domes ic p ices a e no con inuously ixed by o eign p ices bu can
mo e wi hin some unspeci ied band a ound pu chasing powe pa i y.
This esul equi es an al e na i e explana ion o he beha iou o
domes ic p ices in he sho o in e media e un. Al e na i ely, one could
a gue ha pu chasing powe pa i y only applies o in e na ionally
aded goods. Non adables a e howe e also pa o he domes ic gen-
e al p ice le el. Pu chasing powe pa i y has he e o e some implica ions
o ela i e p ices, bu is no a comple e heo y o he gene al p ice le el.
The second poin o c i icism is ha ixing sho - e m in e es a es in
acco dance wi h in e es a e pa i y will no au oma ically s abilize he
economy (compa e he amilia Poole (1970) analysis when money
demand shi s domina e he sys em).4 E en in he IS-LM model s abiliza-
ion depends on he shocks o he IS cu e. Howe e , pe haps mo e
impo an ly, since he 1960s, mone a is s such as B unne and Mel ze
ha e a gued ha he IS-LM analysis igno es dis u bances in o he inan-
4 To limi he size o he pape we do no p esen a de ailed model, bu e e o
o he au ho s. The a gumen s ha ollow ep esen a mo e o less s aigh o wa d
applica ion o he mone a is heo y o money, c edi , ou pu , and p ices asso-
cia ed wi h B unne and Mel ze ( o example, B unne and Mel ze , 1993; also
see Bo do, Choudh i and Schwa z, 1987 o some empi ical suppo ). Ou analy-
sis is also ela ed o he wo k o Good iend (1987, 1991) and o he s on in e es -
a e smoo hing and p ice le el s a iona i y. In e es - a e smoo hing is wha
emains o adi ional ixed-exchange- a e open-economy models once he
assump ion o con inuous pu chasing powe pa i y ails. Compa ed o he IS-LM
model, he B unne -Mel ze analysis allows a wide ange o economic dis u b-
ances o cause base d i o mone a y agg ega es and p ice-le el non-s a iona i y.
Compa e Daniels and VanHoose (1995) on base d i and p ice le el s a iona i y in
open economies. Seph on (1989) examines consequences o exchange- a e smoo h-
ing objec i es o mone a y au ho i ies.
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Mone a y and Non-Mone a y Analyses o In la ion 59
cial ma ke s. Recen ly, Be nanke and Blinde (1988) ha e ekindled
a en ion o his line o a gumen , by illus a ing he e ec s o he simple
addi ion o a ma ke o bank c edi o he IS-LM model. In sho , he
al e na i e s o y based on impe ec subs i u ion be ween inancial ma -
ke s is as ollows. Like cen al banks in mos o he indus ial coun ies,
he Du ch cen al bank uses i s le e age o e he sho - e m in e es a e
as i s main policy ins umen . In pa icula , he sho - e m in e es a e
is employed o main ain a ixed DMa k/Guilde exchange a e. The
equi ed in e es a e ollows di ec ly om in e es a e pa i y is-à- is
Ge many when we se he expec ed a e o dep ecia ion a ze o (igno ing
isk p emiums). Howe e , whe eas he policy ela ed sho - e m in e es
a e applies o he ma ke o mone a y base o bank ese es, he
demand and supply o money as well as he demand and supply o bank
c edi o he p i a e sec o do no depend on his sho - e m in e es a e
alone. They depend on he en i e spec um o in e es a es, including
in e es a es on bank loans, a es o e u n on in es men s in physical
capi al, eal es a e, commodi ies, gold, e c. In a simple al e na i e o he
IS-LM model, all we need is a second in e es a e. Pe haps we can limi
ou hough s o a second, long- e m in e es a e ep esen a i e o con-
sump ion, sa ing, in es men decisions in he eal economy.
In his al e na i e model wi h mo e de ails o di e en inancial ma -
ke s, he esul s om he s anda d IS-LM model end o b eak down.
The cen al bank mus accommoda e any inc ease in he demand o
ese es in o de o s abilize he sho - e m in e es a e a ound i s
a ge p ede e mined by he commi men o ixed exchange a es. In la-
iona y booms can s a om dis u bances in a wide ange o eal and
inancial ma ke s. Impo an is ha money and c edi can expand o
inance in la iona y booms, e en when he demand o money is s able.
The mone a y app oach o in la ion s a es ha money g ow h in excess
o he economy's long- un g ow h po en ial ul ima ely causes he gene al
p ice le el o d i upwa d. In he long un, a gap be ween domes ic and
o eign p ices will esul in cu en -accoun p oblems and p obably a
specula i e a ack in he o eign-exchange ma ke . Pu chasing powe
pa i y is howe e a long- un cons ain and canno be employed as a
sho - e m ancho o domes ic p ices.
We conclude ha wi h ixed exchange a es he cen al bank loses i s
ins umen (s) o con ol he g ow h a e o he money s ock. The sho -
e m in e es a e ha co esponds o a sho - un a ge o he exchange
a e need no coincide wi h he in e es a e ha co esponds o long- un
in la ion objec i es o he domes ic economy. Mo e elabo a e models
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66 Da id J. C. Sman and Je oen Melge
Table 1
OLS es ima es o he P-s a model o he Ne he lands, 1953 - 1992a
(1) (2) (3) (4) (5)
¿Pi Ap AP Ap
cons an 1.104 1.311 1.301 1.045 1.001
(2.30) (2.77) (2.72) (2.25) (2.13)
(p-p'X-i -0.285 -0.269 -0.272 -0.314 -0.312
(3.31) (3.23) (3.23) (3.86) (3.88)
AP -i 0.752 0.709 0.711 0.728 0.728
(7.97) (7.63) (7.57) (8.22) (8.17)
Ape^ 0.023 0.023 0.025 0.025
(2.04) (2.01) (2.27) (2.30)
(KR-1 - KR* .x 0.079 0.119
(0.56) (0.75)
(LR-1 - LR8® X., -0.400 -0.489
(2.23) (2.27)
Reg .s a .
Adj R2 0.65 0.68 0.67 0.71 0.71
S.E. 1.637 1.571 1.586 1.490 1.500
D.W. 2.05 1.90 1.92 1.99 2.01
LM4 P ob 0.362 0.079 0.094 0.220 0.241
ARCH4 P ob 0.291 0.790 0.785 0.949 0.721
a Absolu e - alues in pa en heses. The dependen a iable is he log a e o change o he implici GNP
de la o .
le el signi icance. Including he change in he unemploymen a e is con-
sis en wi h he esul s o ou wage equa ion and co esponds o esul s
in o he s udies.
Column 2 con ains he wage equa ion. I appea s ha wages do no
adjus wi h a lag. Nominal wages inco po a e ull compensa ion o p ice
inc eases: we canno ejec he hypo hesis ha he coe icien o nominal
wage changes wi h espec o p ice changes is one. The e o e, column 2
is essen ially a eal wage equa ion. Real wages inco po a e pa o he
gain in labou p oduc i i y and a e nega i ely ela ed o unemploymen .
A ea u e ha e u ns in all ou es ima es is ha he e appea s o be no
signi ican o wa d shi ing o axes and social secu i y con ibu ions.
Ou indings he e o e con adic esul s epo ed in o he s udies o
Du ch wages ( o example, Knoes e and an de Wind , 1987; G aa -
landy 1992; cu en mac oeconomic models o he Du ch Cen al Plan-
ning Bu eau). On he o he hand, insigni ican coe icien s a e no
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Mone a y and Non-Mone a y Analyses o In la ion 67
uncommon in he li e a u e ( o example, Bean, Laya d and Nickell,
1986; G aa land, 1990). One explana ion o ou indings migh o cou se
be ha we simply used di e en de ini ions o p ices and/o axes and
ha hese di e ences show o be signi ican . A di e en explana ion cen-
Table 2
OLS es ima es o he socio-poli ical model o he Ne he lands, 1953 - 1992a
(1)
Ap
(2)
Aw
(3)
Aw
(4)
Aw
(5)b
Ap
(6)<
Ap
(7)
Ap
(8)c
Ap
cons an 0.282
(0.70)
0.012
(0.02)
-0.521
(0.64)
-0.470
(0.61)
cons an 0.976
(1.61)
0.958
(1.70)
1.043
(1.63)
0.868
(1.88)
lag dep. 0.342
(3.89)
0.072
(0.54)
0.013
(0.10)
0.032
(0.24)
lag dep. 0.608
(4.83)
0.536
(4.50)
0.163
(0.89)
0.550
(5.76)
Ax, -0.214
(2.17)
0.482
(2.88)
0.469
(2.68)
0.428
(2.54)
Ax, 0.227
(1.51)
-0.004
(0.03)
0.006
(0.04)
Aim, 0.052
(1.85)
-0.007
(0.12)
0.011
(0.18)
-0.009
(0.17)
Aim, 0.112
(2.70)
0.121
(3.16)
0.112
(3.12)
0.122
(3.35)
AU 0.165
(1.03)
-0.635
(2.41)
-0.342
(1.05)
-0.504
(1.85)
AU 0.048
(0.19)
0.015
(0.06)
0.000
(0.00)
ATAX 0.057
(0.59)
-0.060
(0.33)
0.051
(0.27)
-0.007
(0.04)
ATAX 0.135
(0.90)
0.056
(0.39)
0.048
(0.32)
Aw 0.451
(7.63)
AW;-1 0.317
(2.23)
Ap 1.157
(5.35)
1.139
(4.86)
1.188
(5.58)
AW;-2 0.359
(3.26)
0.364
(3.68)
Sd -0.003
(1.31)
0.370
(3.14)
Sil 0.024
(1.84)
0.018
(1.53)
Sn, -0.003
(0.29)
AD 0.219
(0.92)
AT -0.212
(0.35)
Reg .s a .
AdjR2 0.86 0.77 0.77 0.78 0.66 0.70 0.69 0.72
S.E. 1.052 1.918 1.891 1.880 1.629 1.520 1.542 1.459
D.W. 2.07 1.61 1.72 1.69 2.34 2.37 2.33 2.41
LM4 P ob 0.537 0.595 0.885 0.897 0.183 0.516 0.539 0.431
ARCH4 P ob 0.130 0.849 0.489 0.489 0.999 0.585 0.591 0.606
No es. a Absolu e - alues in pa en heses. b Wage p essu e on p ices Aw*- 1 equals cu en nominal wage
g ow h in excess o expec ed p ice change and expec ed p oduc i i y gains. Expec a ions acco d o a ional
expec a ions hypo hesis and hus a e p oxied by ac ual alues. c Wage p essu e on p ices Aw*' 2 equals las
yea 's nominal wage g ow h in excess o las yea 's p ice change.
51
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68 Da id J. C. Sman and Je oen Melge
es on sample pe iods and ime se ies cha ac e is ics. When we exam-
ined ou ax- a e a iable we ound ha o he pe iod 1958-1975 bo h
in la ion and he ax a e exhibi ed an upwa d sloping end. Howe e ,
whe eas in la ion measu ed by he implici GNP de la o d opped sha -
ply be ween 1975 and 1987, he ax a e emained app oxima ely s able
be ween 1975 and 1988 - 89. These obse a ions sugges spu ious eg es-
sion p oblems in sho e sample pe iods.
Acco ding o he socio-poli ical model labou mili ancy is an impo an
de e minan o wages and p ices. We examined i e indices o labou
union mili ancy: he pe cen age a e o change o labou union membe -
ship (AT), membe ship o labou unions ela i e o labou o ce (le els
D, changes AD), numbe o s ikes (Sn) and wo king days los due o
s ikes (Sd).11 I hese indices o labou union mili ancy a e measu es o
he same phenomenon, we expec he indices o exhibi a high deg ee o
posi i e co ela ion. This is no he case howe e . Only in one case does
he co ela ion coe icien be ween indices o mili ancy exceed 0.5.
We no e ha labou union membe ship ends o all when unemploy-
men is highe . We also no e ha s ike ac i i y measu ed by Sn is lowe
when unemploymen is highe . These co ela ions indica e ha i may be
e y di icul o dis inguish be ween he in luence o labou union mili-
ancy and no mal labou ma ke p essu e on ( eal) wages when we con-
side only hei coe icien s in he wage equa ion. Mo eo e , ou esul s
Table 3
Co ela ion coe icien s o indices o labou -union mili ancy, 1953-1992
D AD Sn Sd U AU
AT 0.225 0.721 0.174 0.047 -0.517 -0.454
D 0.309 0.354 0.035 -0.889 0.146
AD 0.041 -0.087 -0.472 -0.390
Sn 0.371 -0.450 -0.323
Sd -0.077 -0.032
U 0.137
n We disca ded he absolu e le el o labou union membe ship (T) because i is
a se iously nons a iona y a iable. Mo eo e , he ac i i y o unions ela ed o yea
o yea changes in wage a es is mo e likely o be e lec ed in he a e o change o
membe ship han i s absolu e le el.
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Mone a y and Non-Mone a y Analyses o In la ion 69
a e consis en wi h a ela ionship unning om business es uc u ing
wi h highe unemploymen , o ewe p o es s ikes and lowe ( eal)
wage inc eases. The esul s do no suppo he al e na i e iew ha mo e
s ikes aise eal wages and cause highe unemploymen , because he
ac ual co ela ion be ween s ike ac i i y and unemploymen is nega i e.
The ex ended wage equa ion in column 3 does no yield signi ican
coe icien s o he labou union mili ancy indices. Only he numbe o
s ikes Sn yields a ma ginally signi ican coe icien ha ca ies he
co ec sign. We also obse e howe e ha because o mul icollinea i y
he mili ancy a iables educe he signi icance o he unemploymen
a e.
The es ima es indica e ha wage changes a e he mos impo an
explana o y a iable o p ices (column 1). We ha e indica ed be o e ha
he esul s canno ell us whe he hese esul s should be in e p e ed in
e ms o a mone a y model whe e nominal wages a e only pa o a gen-
e al ansmission mechanism, o whe he wages ep esen an independ-
en cos -push elemen associa ed wi h socio-poli ical models o in la ion.
Columns 5 o 8 o able 2 con ain quasi- educed- o m equa ions o
p ices. In each column we sligh ly ede ine ou measu e o wage p es-
su es on p ices and a emp o ob ain addi ional in o ma ion on wage-
p ice beha iou . In column 5 he hypo hesis is ha in la ion could esul
om pe sis en a emp s by labou o aise expec ed eal wages in excess
o expec ed p oduc i i y gains: AwJ = (Aw
e - Ap® - Ax®). The es i-
ma es p o ide some suppo o his iew. I we assume ha expec a ions
acco d wi h he a ional expec a ions hypo hesis we ind ha p ices do
indeed eac posi i ely o excess wage claims. In column 6 he hypo hesis
is ha i ms aise p ices because in he p e ious pe iod nominal wages
inc eased mo e han p ices: AwJ = (Aw _i - Ap _i). The e o e, eal
wages ha e inc eased and i no compensa ed by gains in labou p oduc-
i i y his yea , i ms will a emp o aise p ices and eclaim hei p o i
sha e o p oduc ion. This in e p e a ion o wage-p ice beha iou is sup-
po ed by he signi ican coe icien o he lagged eal-wage change. We
would ha e liked o see a signi ican coe icien o labou p oduc i i y
in his case. Al hough labou p oduc i i y en e s he p ice equa ion wi h
he co ec nega i e sign i s coe icien is no signi ican ly di e en om
ze o. One in e p e a ion could be ha , in ac , lagged changes in eal
wages do co ec ly an icipa e o o he wise induce u u e gains in labou
p oduc i i y.
In column 7 we examine whe he we can iden i y independen e ec s
o mili ancy a iables on p ices. I , acco ding o he socio-poli ical
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70 Da id J. C. Sman and Je oen Melge
model, labou mili ancy is an impo an de e minan o wages mili ancy
a iables should also be an impo an explana o y a iable o p ices.
Clea ly, he e is no such e ec on p ices.
O e all, we selec he model in column 6 as he bes model and ep e-
sen a i e o he socio-poli ical app oach o in la ion. Howe e , in column
8 we elimina e he insigni ican a iables o labou p oduc i i y and he
ax bu den. Fu he mo e, despi e i s s ong heo e ical appeal, we also
choose o elimina e unemploymen om he inal model. Fo he sho e
pe iod 1953 - 1982, he es ima ed e ec s o unemploymen a e implausi-
ble in he con ex o he no mal wage model (yielding a ma ginally signi -
ican , posi i e coe icien ) and he ou -o -sample esul s o an equa ion
ha included unemploymen we e wo se han an equa ion wi hou unem-
ploymen e ec s. In he socio-poli ical model he unemploymen a e
unc ions as a measu e o he ba gaining s eng h o labou . Highe unem-
ploymen lowe s union powe , mode a es wage claims and should he e-
o e imply lowe a es o p ice changes. The es ima ed posi i e co ela-
ion be ween unemploymen and in la ion is o cou se ypical o "s ag-
la ion" in he 1970s and can be in e p e ed as showing he in luence o
agg ega e supply side shocks o he mac oeconomy. The posi i e co ela-
ion can also be a mani es a ion o inside -ou side p oblems in he
labou ma ke . Acco ding o he inside -ou side heo y o unemploy-
men , inside s (wo ke s being employed and he e o e inside he i m) can
claim la ge wage inc eases, bu a he expense o mo e unemploymen
and wi hou ou side s (wo ke s unemployed and he e o e ou side he
i m) ha ing any mi iga ing in luence on wages which would allow hem
o e u n o employmen a compe i i e (lowe ) eal wage le els. In his
case, ou side s become pa o wha is al e na i ely labelled he s uc-
u al, na u al o he non-accele a ing-in la ion a e o unemploymen .
3. An E alua ion o he P-S a and Socio-Poli ical Models
a) In-Sample E alua ion
Figu es la and b show he ac ual and i ed p ice changes om he
wo i al in la ion models. Thei explana o y alue as measu ed by he
adjus ed R-squa ed is basically he same: 0.71 o he P-s a model
( able 1, column 4) and 0.72 o he socio-poli ical model ( able 2,
column 8).
So-called J- es s can be employed o es whe he one i al model con-
ains in o ma ion o e and abo e he in o ma ion con ained in ano he
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Mone a y and Non-Mone a y Analyses o In la ion 71
ac ual i ed p-s a
Figu e
1
a: Ac ual and i ed in la ion om he P-s a model
( able 1, column 4), 1953 - 1992.
ac ual i ed soc—pol
Figu e
1
b: Ac ual and i ed in la ion om he socio-poli ical model
( able 2, column 8), 1953 - 1992.
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72 Da id J. C. Sman and Je oen Melge
model. The es consis s o adding i ed alues om one i al model as
an explana o y a iable o he o he model. The null hypo hesis o no
ejec ing model i in a o o model j is es ed by examining he - alues
o he coe icien o i ed alues o model i in model j. I he coe icien
o i ed alues om model i is signi ican ly di e en om ze o, we con-
clude ha model i is no ejec ed by model j.
I he null hypo hesis is ha he P-s a model (j) does no ejec he
socio-poli ical model (i), he - alue o gi o he ull sample 1953-92 is
3.60 and we accep he null-hypo hesis. Equally, he null hypo hesis ha
he P-s a model (i) canno be ejec ed by he socio-poli ical model (j) is
also accep ed wi h a - alue o gi o 2.77.
An al e na i e es s a is ics is based on he Da idson-MacKinnon
encompassing es . Fi ed alues y i i and y i 2 om 2 i al models a e
used as eg esso s o explain ac ual alues o in la ion:
I model 1 is ue ( alse), hen he ue alue o 8 is one (ze o). The
coe icien o he i ed alues o he P-s a model is 0.419 wi h a -s a-
is ic o 2.39. The coe icien o he i ed alues o he socio-poli ical
model is 0.596 wi h a -s a is ic o 3.42.
These esul s a ibu e abou equal weigh o bo h models. I appea s
ha o he pe iod 1953 - 92 nei he model is able o ejec he o he as
an adequa e desc ip ion o p ice beha iou .
y = 6y i i + (1 - 6) y i 2.
Table 4
In-sample es s o i al in la ion models, 1953 - 92
J- es s in la ion model Encompassing es
PSTAR SOCPOL
FITPSTAR
( - alue)
0.574
(2.77)
0.419
(2.39)
FITSOCPOL
( - alue)
0.760
(3.60)
0.596
(3.42)
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Mone a y and Non-Mone a y Analyses o In la ion 73
b) Ou -o -sample e alua ion
Ano he way o compa e al e na i e models is o examine hei ela i e
ou -o -sample pe o mance. We e-es ima ed bo h models o he sho e
pe iod 1953-1982 and ob ained he equa ions
Ap = 0.910 - 0.339 (p-p') -i + 0.764 Ap _i + 0.027 Ape _i - 0.412 (LR1*1 - LR
(1.06) (3.11) (5.71) (1.62) (1.57)
Adj R2 = 0.59 S.E. = 1.630 D.W. = 2.04
(14)
Ap = 1.387 + 0.511 Ap _! + 0.118 Aim + 0.318 A(w - p) _i
(1.99) (4.17) (2.63) (2.85)
Adj R2 = 0.63 S.E. = 1.540 D.W. = 2.15
(15)
I we include he change in he unemploymen a e in he socio-poli i-
cal model i s coe icien o he 1953- 1982 pe iod is +0.448 ( -s a is ic
1.43). We sugges ed abo e ha his "s ag la ion"- ype o esul appea s
o con adic he heo e ical in e p e a ion o he unemploymen a e in
he socio-poli ical model. Fo his eason we igno e he s ong heo e ical
appeal o include unemploymen e ec s on wages and p ices. (We p o-
ide some esul s bu only o compa ison.)
Figu e 2 p esen s he ac ual and i ed p ice changes in he ou -o -
sample pe iod 1983 - 1992 (using ac ual alues o he explana o y a i-
ables). Bo h models explain he gene al ime pa e n o p ice changes.
On a e age, howe e , he ou -o -sample p edic ion e o s o he P-s a
model a e be e han hose o he socio-poli ical model. Mean absolu e
e o and oo mean squa ed e o o he P-s a p edic ion e o s a e
lowe . We ind ha he mean p edic ion e o o he socio-poli ical model
is signi ican ly di e en om ze o and he e o e biased.
We can o mally es whe he he p edic ion e o s o one model can be
explained by p edic ions om ano he model. The p edic ion e o s o
model i a e eg essed on ( j - j), he di e ence be ween he p edic ions
om model j and i
e{ =/M { - i) + u .
We conclude ha model i p o ides be e p edic ions han model j i
Pii is no signi ican ly di e en om ze o, while a he same ime
does di e signi ican ly om ze o. Wi h P-s a as model (i) and socio-
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74 Da id J. C. Sman and Je oen Melge
Table 5
Summa y o ou -o -sample p edic ion e o s
Mean e o (MEAN), mean absolu e e o (MAE) and oo mean
squa ed e o (RMSE), 1983 - 1992
MEAN MAG RMSE
P-s a model 1.580 0.988 1.185
Socio-poli ical model 2.676 1.211 1.520
(incl. AU ) (2.398) (1.242) (1.792)
Table 6
Ou -o -sample J- es s
P-s a e o s Socpol e o s
coe icien -0.357 -0.643
( -s a is ic) (1.90) (3.43)
poli ical model being model (j), he - alue o 0ij is 1.90 and o i^ he
- alue is 3.43. We conclude ha he ou -o -sample pe o mance o he
P-s a model is signi ican ly be e han he ou -o -sample pe o mance
o he socio-poli ical model.
IV. Concluding Rema ks
Con a y o he mone a y app oach o in la ion emphasized in economic
ex books, mos o he public deba e abou ( he p e en ion o highe ) in la-
ion usually e e s o wage cos s, public sec o p ice inc eases, e c. This is
puzzling because mone a y economics e e s o his line o hinking as he
cos -push my h (see o example Ba en, 1981). The essence o he well-
known s a emen "in la ion is a mone a y phenomenon" is ha in la ion,
de ined as he long un upwa d d i o he gene al p ice le el, canno
occu wi hou a co esponding inc ease in money. The basis o his s a e-
men es s in he s ong ela ionship be ween money and p ices which has
long been es ablished. Because cen al banks a e able o con ol he a e o
g ow h o money, i and when hey eally wan o, hey mus bea he p i-
ma y esponsibili y o in la ion.
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Mone a y and Non-Mone a y Analyses o In la ion 75
ac ual o ecas p-s a o ecas soc-pol
Figu e 2: Ac ual p ice changes and ou -o -sample o ecas s om he P-s a
and socio-poli ical models, 1983 - 1992.
Wi hin he Eu opean Mone a y Sys em o ixed exchange a es, he
Du ch cen al bank has e ec i ely elinquished con ol o e i s mone a y
ins umen s o he Ge man Bundesbank. S anda d mac oeconomic
heo y in o ms us ha i he objec i e o a ixed exchange a e is o
emain c edible, in la ion in he Ne he lands mus ul ima ely equal in la-
ion in Ge many.12 The mechanism h ough which his occu s is he
adjus men o Du ch in e es a es and money g ow h consis en wi h he
exis ing demand o money. We ha e a gued ha ixed exchange a es
and pu chasing powe pa i y ac only as a long- un cons ain on p ices.
Impe ec in eg a ion be ween eal and inancial ma ke s means ha we
s ill need a domes ic explana ion o p ice beha iou in he sho o
in e media e pe iod. Ou c i ical e alua ion o he ex book IS-LM
12 The implici assump ion being ha he Du ch and Ge man economies a e
simila wi h espec o impo /expo o adable/non adable goods baske s and
simila wi h espec o p oduc i i y g ow h in hese sec o s.
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