Asymmetric Adjustment Costs and The Dynamics of Housing Supply

This paper considers the potential effects of asymmetric adjustment costs on the dynamics of housing supply. The model in Section 2 provides explicit microfoundations for the divergence between long and short run supply elasticities and also predicts asymmetric adjustment whereby positive deviations from equilibrium are associated with faster adjustment as compared with corresponding negative deviations. The paper also tests for asymmetric adjustment costs by estimating a number of asymmetric and/or non-linear equilibrium correction models using data on the Irish housing market. A number of interesting insights into the dynamics of housing supply have been uncovered. Firstly, and most importantly, the empirical section estimated a unit elastic equilibrium housing supply curve which suggest Irish housing supply is significantly less elastic than housing supply in other economies such as the US. The finding of only a unit elastic long-run housing supply curve means that there would appear to be significant constraints on the supply side of the market even in the long-run. Secondly, of the six models considered, all are supportive of the proposition that the adjustment costs associated with an expansion in housing output are greater than the adjustment costs associated with a contraction. This gives rise to relatively slow upward adjustment of housing output in response to a surge in demand. Thirdly, a number of the estimated models support the belief that there are threshold points on the supply side of the housing market: large deviations from equilibrium appear to be associated with faster adjustment when compared with small deviations from equilibrium. Indeed, over a small interval about the estimated equilibrium, the adjustment of housing supply is not significantly different from zero. Such inertial supply behaviour is consistent with optimising behaviour under adjustment costs non-convexities. In conclusion, it appears that the above models with both asymmetries and non-linearities can capture important empirical features of the supply side of the housing market. One not insignificant shortcoming associated with these models, however, is that it is very difficult to distinguish them in-sample from corresponding linear symmetric specifications. Only in the case of the cubic polynomial adjustment mechanism was it possible to statistically distinguish the asymmetric non-linear adjustment from a nested model with symmetric linear adjustment. Future research should therefore examine the extent to which it is possible to distinguish between competing models in terms of out-of-sample forecasting.

Capacity Utilisation in Irish Manufacturing

Capacity Utilisation (CU) measures play an important role in practical economic analysis. Variation in the extent to which existing capacity is being utilised provides an indication of how the supply side of a particular industry, sector or economy is evolving relative to its demand side. Such measures have been used to explain changes in investment flows and the general economic environment. However, the primary significance of CU measures stems from their usefulness in uncovering upward pressure on the price level (i.e. inflation). This paper reviews some of the more common methods of calculating measures of capacity utilisation. All methods are shown to have their own specific advantages and disadvantages. The available monthly survey measures are currently the most accessible and perhaps the most useful from a policy viewpoint given the high frequency with which they become available. However, there is a large degree of uncertainty about what these surveyed measures actually mean. The paper has also applied the recently popularised cost function approach to measuring CU. In recognition of the dichotomy which characterises Irish industry, the model was also fitted to two individual sub-sector classifications: Hi-technology and Traditional manufacturing. The results suggest that a substantial degree of excess capacity existed in Irish manufacturing between 1970 and 1990. The constructed CU measure is also examined as a possible indicator of inflationary pressure. No significant relationship between CU and inflation was found in either the Total or Hi-Technology sectors. However, the CU ratio for the Traditional sector was found to be significantly positively related to Irish inflation.

Low Inflation or Price Stability? A Look at the Issues

This paper examines whether monetary authorities should aim for low inflation or price stability. It first outlines and assesses many of the costs of inflation. Some of these, such as the distortionary effect upon the tax system, have been shown to involve significant welfare costs, even at very low inflation rates. When a variety of estimates of the transitional costs of moving to price stability are set against the permanent benefits of getting there, the evidence strongly favours the objective of stable prices. Some commentators argue, however, that there may be permanent costs associated with price stability, such as higher equilibrium rates of unemployment and less effective monetary policy. These arguments are not short of their critics, however, who suggest that such costs either do not exist, or are likely to be unimportant in practice. Overall, it is not possible, given the current state of economic knowledge, to arrive at a definite value for the optimal rate of inflation, although the evidence reviewed in this paper suggests that price stability may be optimal.

Non-Traded, Traded and Aggregate Inflation In Ireland (Part 2)

This paper attempts to shed further light on the primary determinants of Irish inflation. By way of introduction, the paper provides a critical assessment of the Irish literature to date within the context of several key international theories. Several areas of controversy surface from this review: there exists little or no consensus regarding (a) the main causes of consumer price inflation in Ireland (b) the role of wages in the inflation process and (c) the role played by domestic factors in determining Irish inflation. The main body of the paper attempts to address each of these questions directly. It does so by formulating a model which tests for potentially divergent price determination in the traded and non-traded sectors of the economy. The analysis was facilitated by the construction of a new dataset which decomposed an underlying measure of consumer prices into its traded and non-traded components. For traded price inflation, the results suggest the strong role of the exchange rate and foreign inflation in conformity with the small open economy view. In the case of non-traded prices, the data rejected a strict version of the small open economy view. Nonetheless the strong role of the exchange rate and foreign prices was confirmed even for the non-traded sector. Furthermore, in the case of both traded and non-traded inflation, there was also significant evidence that real wage growth in excess of that which is warranted by productivity gains can lead to higher inflation. As would be expected, the results for aggregate inflation fall somewhere between those for its traded and non-traded components.

Some lessons from the financial crisis for the economic analysis

The economics profession in general, and economic forecasters in particular, have faced some understandable criticism for their failure to predict the timing and severity of the recent economic crisis. In this paper, we offer some assessment of the performance of the Economic Analysis conducted at the ECB both in the run up to and since the onset of the crisis. Drawing on this assessment, we then offer some indications of how the analysis of economic developments could be improved looking forward. The key priorities identifi ed include the need to: i) extend existing tools and/or develop new tools to account for important feedback mechanisms, for instance, improved real-fi nancial linkages and non-linear dynamics; ii) develop ways to handle the complexity arising from the presence of multiple models and alternative economic paradigms; and iii) given the limitations of point forecasts, to further develop risk and scenario analysis around baseline projections. JEL Classification: C43, D91, E31, E52, E58euro area, financial crisis, MACRO ECONOMIC FORECASTING

Exchange Rate Pass-Through and Irish Import Prices

This study assesses the extent to which exchange rate changes affect Irish import prices (i.e. the extent of exchange rate pass-through, PT) by analysing data from the 1963 to 1995 period. The paper fills two important gaps in the literature: i) by making due allowance for the time series properties of the data and ii) by concentrating on the case of a small open economy. The majority of international empirical studies in the area do not provide support for full, or close to full, PT. Reasons put forward for this finding include the "menu" costs associated with altering prices, hedging techniques, intra-firm pricing by multinationals, the existence of non-tariff barriers, and the entry/exit of firms associated with exchange rate induced price changes. If the proposition of monetary neutrality is accepted, however, full PT would be expected to hold over the medium to long run. Many previous studies assess the degree of PT by relating import prices to the exchange rate, foreign costs and domestic competing prices. The usual approach involves estimating a single equation and using the estimated coefficients to assess the degree of PT. It is argued in this paper, however, that such single equation estimation will lead to estimates of the degree of PT which appear too low because the strong relationship between import and domestic-competing prices will not be properly taken into account using such a technique. This study makes use of the so-called Johansen technique to allow for this problem and uncovers two long-run relationships among the data, i.e. one between import unit values, the exchange rate and foreign costs and another between domestic competing prices and the same two variables. In so doing, it confirms the existence of very close to full PT in the case of both Irish import prices and domestic competing prices. Many of the previous results in the literature demonstrating substantially less than full PT may be due to the failure to make proper allowance for the time series properties of the data or for the strong relationship which exists between import and domestic competing prices. Finally, it is found that the speed of adjustment to the long-run relationships appears to be quite low, thus supporting the existence of incomplete PT in the short run.

The rationality of consumers' inflation expectations: survey-based evidence for the euro area

This paper uses survey data to assess consumers' inflation expectations in the euro area. The probability approach is used to derive quantitative estimates of inflation expectations from the European Commission's Consumer Survey. The paper subsequently analyses the empirical properties of the estimated inflation expectations by considering the extent to which they fulfil some of the necessary conditions for rationality. The results suggest an intermediate form of rationality. In particular, the surveyed expectations are an unbiased predictor of future price developments and they incorporate - though not always completely - a broad set of macroeconomic information. In addition, although persistent deviations between consumers' expectations and the rational outcome have occurred, consumers are shown to rationally adjust their expectations in order to eventually 'weed out' any systematic expectational errors. Interestingly, perhaps reflecting changes in the monetary regime, there is also evidence of 'growing' rationality over the 1990s compared with the 1980s. JEL Classification: D12, D84, E31euro area, inflation expectations, Rationality, Surveys

A Monetary Approach to the Analysis of Inflation in Ireland

This paper formulates a simple monetary model to analyse the role of money in the determination of inflation in Ireland. The model suggests that monetary disequilibrium can affect inflation directly via the exchange rate and indirectly by increasing the rate of inflation in the non-traded relative to the traded sector. Econometric results support the proposition that monetary disequilibrium has impacted positively on the rate of inflation in Ireland. A measure of monetary imbalance is shown to add significantly to the information provided by purchasing-power-parity and real-wage error correction mechanisms in the analysis of inflation. However, the impact of monetary disequilibrium would appear to have been much more significant during the early 1980s.

Non-Traded, Traded and Aggregate Inflation In Ireland (Part 1)

This paper attempts to shed further light on the primary determinants of Irish inflation. By way of introduction, the paper provides a critical assessment of the Irish literature to date within the context of several key international theories. Several areas of controversy surface from this review: there exists little or no consensus regarding (a) the main causes of consumer price inflation in Ireland (b) the role of wages in the inflation process and (c) the role played by domestic factors in determining Irish inflation. The main body of the paper attempts to address each of these questions directly. It does so by formulating a model which tests for potentially divergent price determination in the traded and non-traded sectors of the economy. The analysis was facilitated by the construction of a new dataset which decomposed an underlying measure of consumer prices into its traded and non-traded components. For traded price inflation, the results suggest the strong role of the exchange rate and foreign inflation in conformity with the small open economy view. In the case of non-traded prices, the data rejected a strict version of the small open economy view. Nonetheless the strong role of the exchange rate and foreign prices was confirmed even for the non-traded sector. Furthermore, in the case of both traded and non-traded inflation, there was also significant evidence that real wage growth in excess of that which is warranted by productivity gains can lead to higher inflation. As would be expected, the results for aggregate inflation fall somewhere between those for its traded and non-traded components.

Non-Traded, Traded and Aggregate Inflation in Ireland: Further Evidence*

This paper addresses the unresolved issues surrounding the determination of Irish inflation. The study tests the validity of i) a pure wage mark-up model ii) a pure small open economy model and iii) a hybrid model which fuses elements of i) and ii) over the period 1979:Q1-1995:Q3. Multivariate cointegration techniques are employed to clearly distinguish the long- and the short-run information in the data. The results highlight the relevance of the distinction between traded and non-traded prices. For traded prices, full purchasing power parity (PPP) was found to be consistent with the data. In the case of non-traded prices, the data reject strict long-run PPP. Aggregate price results occupy an intermediate position. Finally, the paper demonstrates that strong bi-directional feedback exists between prices and wages.