Degree Name

Master of Arts (MA)

Semester of Degree Completion

1992

Thesis Director

Minh Q. Dao

Abstract

The purpose of this thesis is to examine some of the various non-monetary effects on inflation within the framework of the price-gap model. Some of the non-monetary shocks that can affect inflation include wage adjustments, changes in basic commodity prices (for example, crude oil), changes in the exchange rates, and shifts in inflationary expectations.

In April of 1989, a study was put out by the Federal Reserve (staff study 157) that examined the relationship between the current price level and an estimate of the long-run equilibrium price level. In the study, an indicator P* (pronounced P-star) was used to estimate what level of prices could be supported by the present money stock. The long-run price level was defined as P*=(MV*)/Q* where M ls the money stock, V* is the long-run equilibrium level of velocity, and Q* is the potential output level. From this the study relates the acceleration of the price level (or changes in the rate of inflation) to the price gap defined as (p-p*) where the lower-case variables are the natural logarithms of the upper-case counterparts. The authors were able to show that, in the long-run, the price gap gives a reasonable explaination of the dynamics of inflation.

This thesis builds on the basic framework of the price gap model particularly with respect to short-run variations in the rate of inflation. The Fed study suggest:

"In the short-run, other characteristics of the economy such as the formation of expectations, lags in wage contracts and in aggregate demand, and the effects of changes in the exhange rate, may affect the inflation process. These factors thus may well affect the estimated dynamics of the model, … and (we) have focused instead on tying down the long-run price level."

This thesis examines the effect of these short-run variations.

The basic form of the model is specified as:

change in rate of inflation = price gap + lagged changes in the rate of inflation + series of non-monetary disturbances

The price gap and the lagged dependent variables are the basic form of the price-gap model used in the Fed study. The non-monetary disturbances to be used are basic commodity prices, exchange rates, wage adjustments, and inflationary expectations. The individual commodity prices that are examined are crude oil, lumber, cotton, copper and scrap steel. These commodities are chosen because they are basic industrial commodities that have the greatest effect on the manufacturing sector of the economy. In addition, a commodity price index is developed that incorporates price movements of the mentioned commodities into a single series. The effects of this index are also examined. Variations in a dollar index are used to model exchanges rates. The dollar index used is a trade weighted basket of 10 foreign currencies published by the Fedral Reserve and is a good proxy for the performance of the dollar relative to foreign currencies. The average weekly wage level for manufacturing is used to model wage adjustments and their impact on inflation. Lastly, an adaptive inflationary expectations disturbance is computed and is tested. All significant disturbances are incorporated into a general model a simulation was run to test the predictive power of the model.

The thesis concludes that variations in commodity prices and wage adjustments have a significant effect on inflation in the short-run. Movements in the exchange rates have a milder effect on inflation while the expectations disturbance had no usefulness at all. The explanatory power of the price-gap model from the Fed study to the general model in this thesis was increased from about 33% to about 47% of total variation in inflation. The simulation showed that the model had reasonable predictive power. Overall, the thesis shows that the price-gap model is flexible enough to be adapted to short-run work.

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