High versus Low Inflation: Implications for Price-Level Convergence
One sentence summary: Lower
inflation rates are associated with higher persistence and slower convergence
of good-level prices.
The corresponding paper by Ege
Yazgan and Hakan Yilmazkuday has been published at Empirical Economics.
Abstract
This paper investigates the
relationship between the level of inflation and regional price-level
convergence utilizing micro-level price data from Turkey during two clearly
distinguishable periods of high and low inflation. The results indicate that
higher persistence and slower convergence of price levels are evident during
the low-inflation period, which corresponds to the inflation-targeting (IT)
regime. During the low-inflation IT regime, inflation convergence across regions
appears to occur more quickly and may be responsible for the slower pace of
convergence in price levels. Overall, IT in Turkey, which was successful in
lowering and maintaining inflation at acceptable levels, also appears to be
associated with faster convergence in inflation rates at the expense of slower
convergence in price levels.
Non-technical Summary
This paper investigates the
regional price-level convergence properties of individual goods in an emerging
market economy, Turkey, which provides a unique data set including two periods
of high inflation (i.e., before inflation targeting, the pre-IT period) and
low-inflation (i.e., inflation-targeting, the IT period).
The results obtained using
state-of-the-art persistence measures indicate that greater persistence and
slower convergence (across regions) are evident for good-level prices during
the low-inflation period (corresponding to the IT regime) compared to the
high-inflation period. The following figure shows the difference of persistence
(or long memory in convergence, measured by d)
in good-level prices between low- and high-inflation periods.
To understand the details of this
result, since, given initial deviations from the Law of One Price (LOP),
convergence in inflation rates would correspond to a divergence in price
levels, we achieve a convergence analysis for inflation rates as well. We show
that, for an increasing number of goods and region pairs, inflation rates have
converged during the low-inflation period, which suggests that relative
convergence in inflation rates might have caused the slower convergence of
price levels during that period. In particular, the following figure shows the
difference of persistence (or long memory in convergence, measured by d) in good-level inflation rates between
low- and high-inflation periods.
In terms of policy implications,
inflation convergence suggests that real regional interest rates (defined as
the difference between nationally determined nominal interest rates and
region-specific inflation rates) have been converging during the low-inflation
period, which indicates the success of the IT regime in Turkey because any
benevolent policy maker (considering inequality) would balance economic
standards (e.g., real variables such as the real interest rate) across regions.
Despite the success of the IT regime in reducing inequality across regions in
terms of real interest rates, the relatively lower convergence of price levels
suggests that market integration has slowed down during the low-inflation
period, which indicates an increase in trade costs (that potentially harm the
national growth rate) across regions (e.g., due to higher energy prices, search
costs) during the same period. Therefore, the low-inflation period in Turkey
coincides with reductions in both inequality and market integration across
regions, which reflects a trade-off from a policy perspective.