Economic Models - Convex Optimization

Inflation Control in Central and Eastern European Countries 179
With this specification, agents extrapolate from the past inflation to formulate
the current period price level. The mechanism of transmission of
monetary policy to inflation is indirect: an expansionary monetary policy
takes place as a decrease in the real rate ī t−1 −¯π t−1 , which boosts the
economic activity in the AD equation; in the second moment, the pressure
on the demand enhances inflation, as illustrated in the PC equation.
The instrument and the mechanism of transmission of monetary policy are
then consistent with the operating procedures of both the FED and of the
Bundesbank, and later of the ECB.
Rudebush and Svensson (1999) allowed for an additional term β y2 y t−2
in the AD equation, but we found that, possibly also due to the smaller
dimension of our samples and the high collinearity with β y2 y t−2 , the contribution
of the two different effects in general could not be distinguished.
We, then considered the proposed AD equation sufficient, also because
one lag proved to be enough to have no serial correlation in the residuals.
Rudebush and Svensson also specified the model without intercepts α 0 ,β 0 ,
having formulated for mean-corrected data, but we preferred to allow for
the constant and test, for its possible exclusion explicitly.
Rudebush and Svensson (2002) remarked that ∑ 4
j=1 α πj = 1 can be
expected as it corresponds to a vertical PC in the long run. They also
explicitly discussed the fact that the backward looking formulation of
the PC and AD equations imply adaptive rather than rationale expectations,
but they argued that this may well be the case especially in a phase
of monetary and inflationary instability; as an alternative, they suggested
that the given specification may simply be considered as reduced form
equations.
Notice that even if the constraint ∑ 4
j=1 α πj = 1 is applied, the model
still does not necessarily impose a unit root to inflation, because the dynamics
of y t has to be taken into account too: consider for example α π1 = 1,
α π2 = α π3 = α π4 = 0, β y = 0, and the monetary policy rule ī t =¯π t + π t ;
the PC equation then becomes β r ∈ y, t+ ∈π, t, thus, inducing a stationary
behavior. It is indeed, precisely by steering the output gap using the interest
rate that the stabilization of inflation is ultimately possible.
This model may well be applied to the transition economies too, especially
considering that the accession of these countries to the EU requires
them to adopt a monetary policy setting that is institutionally compatible
with the one of the ECB. In the case of a small open economy, though,
two other factors should be taken into account: the demand of domestic
products generated by the trade partners and the effect of the international
competition on local prices.