Structural Changes in Inflation


Abstract: The declining inflation experienced during the last decade is a common feature of both the Euro Area and other developed economies. Possible explanations have been the occurrence of exogenous shocks, such as oil prices, effective exchange rates, and import prices. Increased globalization has led to heightened competition in both domestic and international markets, eroding firms’ pricing power. For the United States, productivity growth, which raises the rate at which the economy can grow without giving rise to inflationary pressures, has also been considered. However, the absence of evidence regarding productivity and competition improvements in the Euro Area raises doubts about the validity of such views.
This project aims to study the decline in inflation experienced in Europe during the last few decades and has raised the issue of the structural change hypothesis in this process. I relied on structural break analysis to assess the changes witnessed in inflation from the seventies onwards. The wage and price inflation equations are estimated over the entire sample period, and instability is being tracked through a battery of structural break tests.
We find that the Phillips curve has been modified since 1981. From 1981 onwards, price inflation seems to have been more inertial than it was in the past. On the wage side, labor productivity, as well as the unemployment gap, appear to have played a progressively diminishing role in the wage inflation process. Both results tend to confirm a structural change in the standard Phillips curve. The traditional trade-off between unemployment and wage inflation, if not completely vanished, has significantly diminished over the past two decades.
When considering possible causes of changes in the inflationary process, it appears that trade liberalization has played no role in the lower inflation experienced within the Eurozone. On the contrary, labor market liberalization witnessed in Europe since the mid-eighties would explain some of the decrease in wage inflation.