Assessing the Sensitivity of Inflation to Economic Activity

46 Pages Posted: 24 Jun 2011

See all articles by Konstantins Benkovskis

Konstantins Benkovskis

Bank of Latvia; Stockholm School of Economics in Riga

Michele Caivano

Bank of Italy

Antonello D'Agostino

European Stability Mechanism; Central Bank and Financial Services Authority of Ireland - Economic Analysis and Research Department

Alistair Dieppe

World Bank

Samuel Hurtado

Banco de España

Tohmas Karlsson

European Central Bank (ECB)

Eva Ortega

Bank of Spain, Research Department

Timea Varnai

Magyar Nemzeti Bank

Date Written: June 8, 2011

Abstract

A number of academic studies suggest that from the mid-1990s onwards there were changes in the link between inflation and economic activity. However, it remains unclear the extent to which this phenomenon can be ascribed to a change in the structural relationship between inflation and output, as opposed to a change in the size and nature of the shocks hitting the economy. This paper uses a suite of models, such as time-varying VAR techniques, traditional macro models, as well as DSGE models, to investigate, for various European countries as well as for the euro area, the evolution of the link between inflation and resource utilization and its dependence on the nature and size of the shocks. Our analysis suggests that the relationship between inflation and activity has indeed been changing over time, while remaining positive, with the correlation peaking during recessions. Quantitatively, the link between output and inflation is found to be highly dependent on which type of shocks hit the economy: while, in general, all demand shocks to output imply a reaction of inflation of the same sign, the latter will be less pronounced when output fluctuations are driven by supply shocks. In addition, a sharp deceleration of activity, as opposed to a subdued but protracted slowdown, results in a swifter decline in inflation. Inflation exhibits a rather strong persistence, with a negative impact still visible three years after the initial shock.

Keywords: Demand shock, inflation response, macro model, output growth, Phillips curve

JEL Classification: E31, E32, E37

Suggested Citation

Benkovskis, Konstantins and Caivano, Michele and D'Agostino, Antonello and Dieppe, Alistair and Hurtado, Samuel and Karlsson, Tohmas and Ortega, Eva and Varnai, Timea, Assessing the Sensitivity of Inflation to Economic Activity (June 8, 2011). ECB Working Paper No. 1357, Available at SSRN: https://ssrn.com/abstract=1859985

Konstantins Benkovskis

Bank of Latvia ( email )

Riga
Latvia

Stockholm School of Economics in Riga ( email )

Strelnieku iela 4a
Riga, LV 1010
Latvia

Michele Caivano

Bank of Italy ( email )

Via Nazionale 91
Rome, 00184
Italy

Antonello D'Agostino

European Stability Mechanism ( email )

6a Circuit de la Foire Internationale
L-1347
Luxembourg

Central Bank and Financial Services Authority of Ireland - Economic Analysis and Research Department ( email )

Dame Street
P.O. Box 559
Dublin 2
Ireland

Alistair Dieppe (Contact Author)

World Bank ( email )

1818 H Street, NW
Washington, DC 20433
United States

Samuel Hurtado

Banco de España ( email )

Alcala 50
Madrid 28014
Spain

HOME PAGE: http://www.bde.es

Tohmas Karlsson

European Central Bank (ECB) ( email )

Sonnemannstrasse 22
Frankfurt am Main, 60314
Germany

Eva Ortega

Bank of Spain, Research Department ( email )

Alcala 50
28014 Madrid
Spain

Timea Varnai

Magyar Nemzeti Bank ( email )

Szabadsag ter 8-9
Budapest, H-1850
Hungary

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