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.
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.
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.