1/2000 Urmas Sepp, Andres Vesilind and Ülo Kaasik. Estonian inflation model

Working Papers of Eesti Pank. No 1, 2000

The objective of model-building was an inflation model suitable for prognosis as well as for simulation. The model serves two purposes. First of all, it is a tool for analysing inflation. Secondly, it is part of the model of Estonian economy, which completes the adjustment loop of the macromodel. The theoretical background of the inflation model derives from four basic features of Estonian economy. Namely, Estonia is: a small and open economy, a transitional economy, economy under currency board arrangement and a market economy. When estimating the model, inflation was decomposed into a) underlying inflation which is a long-run process and b) inflation deviations from the equilibrium which are caused by the short-run impact of inflation factors. The underlying inflation, which reflects the convergence, is determined as a trend. The latter was specified as a time function, ARMA process, moving average and HP filter, whereas the best result was obtained with time function. According to modelling output the short run dynamics of the inflation are determined by three main factors - demand pressure reflected by the GDP gap, exchange rate of the US dollar (which is proxy for foreign prices), and administrative action for correcting regulated prices.
The adequacy of the model has been tested on the basis of ex post and ex ante prognosis. The model provided acceptable results in the simulation of endogenous and exogenous shocks

Authors' e-mail addresses: usepp [at] epbe.ee; vesilind [at] epbe.ee; ykaasik [at] epbe.ee

Authors would welcome any comments on the present text. The views expressed are those of the authors and do not necessarily represent the views of the Bank.

Table of Contents

Introduction
1. Theoretical background
1.1. Transitional economy
1.2. Small and open economy
1.3. Currency Board Arrangement (CBA)
1.4. Models of inflation of market economy
2. Underlying Inflation
2.1. Time Function
2.2. Internal convergence
2.3. Other methods of the trend estimation
2.4. Judgement of the reality of time function
3. Short-term equations
3.1. The tradables
3.2. The nontradables
3.3. Other deflators
4. Quantitative analysis
4.1. Dynamic ex post simulations
4.2. Analysis of the shocks.
4.3. Ex ante forecasts
4.3.1. Forecast and assumptions of exogenous variables
4.3.2. Results
5. Interpretation of the model
Summary of the estimation results
Appendix 1. Variables of the Model.
Appendix 2. Data
Appendix 3. ADF Test Statistics
Appendix 4. Statistical Protocols of the Equations
Appendix 5. Figures of the Impact of Endogenous Shock
Appendix 6. The Impact of the Exogenous Shock
Appendix 7. System of Equations
References

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