Who has a relation with infla-

tion? A closer look at Danish

inflation.

Lucas van der Kleij (11004517)

University of Amsterdam
June 2017

ABSTRACT

This paper examines the relation between inflation and unemployment

on monthly Danish data between 1990 and 2015. Although more complex,
Philips findings of a negative relation still holds for Danish data. Economic
shocks were explained by including oil and yield terms. Both showed a
significant effect on inflation.
1 Introduction Previous research are described in section
2, the data and model in section 3 and the
results and conclusion in section 4 and 5,
orldwide, the Philips-curve has been respectively.
W a solid foundation for explaining the
relation between inflation rates and unem-
ployment rates. However, There is general 2 Theory
agreement that the original Philips-curve
equation is to simplistic and lacks explana- 2.1 History and Models
tory power on more recent data. Most eco-
nomics therefore no longer use the original Originally, the Philips-curve, first intro-
model (Hoover 2008). Instead, many use duce by Philips in 1858, aimed to find a rela-
modified versions to account for this lack by tion between money wage changes and unem-
including other indicators. This adds another ployment. As years went by, Samuelson and
dimension of difficulty as to what indicators Solow (1960) made the explicit link between
to use. inflation and unemployment.
Since the philips equation seems to have lost
Understanding what causes inflation is im- its explaining power, because of a more seem-
portant in many aspects. First, high and ingly complex relation. Economists have
volatile inflation causes uncertainty about fu- come up with a variety of models for which
ture prices and reduces real profits (Bagus, many are still based on the philips-equation.
2014, p. 501). This reduces investment and Mankiw (2012) explains that the more com-
slows economic growth. Conversely, defla- plex relation might be influenced by ex-
tion, which typically occurs after an economic pected inflation and the natural unemploy-
1
crisis, encourages people to hold on to their ment (NAIRU) . He introduces the adap-
liquid money. As less is spent prices drop and tive expectations, which assumes that the
production decreases. This increases unem- expected inflation at time t is merely the
ployment en slows economic growth. How- recorded inflation at time t 1. The Mankiw
ever, some inflation seems to have no real model:
effect on economic growth. Sarel (1996) finds P P P n
evidence of a structural break at an inflation t = t t1 = + (ut u ) + t , (1)
rate of 8%; Inflation does not seem to have P n
any effect on economic growth below that with t the real inflation, ut and u the un-
break. employment and the nairu.
Staiger, Stock & Watson (1997) use a compa-
The goal of this paper is to examine the seem- rable model by introducing a matrix Xt which
ingly more complex relation of inflation with consists of other possible indicators, such as:
unemployment. To do this, I aim to find a delayed inflation (autoregressive process) and
model that is powerful, yet simplistic in ex- supply shocks. Another adjustment is to re-
plaining inflation by introducing relative few place ut with ut1 and introduce ut2 . The
important indicators for economic shocks. It Staiger, Stock and Watson model:
differs from that of other research in that I
tP = (1 + 2 )un + 1 ut1 + 2 ut2
use data from Denmark in the period of 1990
through 2015. + 0 Xt + t . (2)
1
See appendix A for the definition
Finally, Gal (2011) adjusts for possible auto-
gressive failures (Gal, 2011, p. 452):
P
tP = + t1 + (ut un ) + 1 (ut1 un )
+ t . (3)
We can generalize many models by the fol-
lowing equation:
tP = + t1
P
+ (ut un ) + 1 (ut1 un )
+ 2 (ut1 un ) + 0 Xt + t . (4)
2.2 Indicators
Recall from the previous section that al-
ready some indicators were mentioned; unem-
ployment, nairu, lagged inflation and lagged
unemployment. Other significant indicators
were found by Batin et al. (2005). Besides
unemployment, they conclude that real im-
port prices and real oil prices play a signifi-
cant role in explaining British inflation. How-
ever, a more recent study of the influence of
oil price changes concluded that the effect of
oil price changes on inflation is limited, even
though crude oil price changes are a major
driver of inflation variability (Alvarez, Hur-
tado, Sanchez & Thomas, 2010).
Given these two contradictory studies it is un-
certain how the effect on Danish economy will
be. A more certain indicator, is the yield
curve. Take in account, that there are dif-
ferent term structures; slope and level. Both
seem to have a significant effect in predicting
inflation Estrella & Mishkin (2005) and Kaya
(2014). However, the level curve seems to be
a better predictor for inflation than the slope
of the yield curve (Kaya, 2005). Interestingly
is the fact that there is no standard theory as
to why the yield curve has a significant effect,
although Estrella & Mishkin (2005) suggest
that the relationship is influenced by mone-
tary policy regime.
2
Data retrieved from the OECD is already seasonal adjusted in contrary to data from the FRED.
3
Retrieved from http://www.oecd.org/about/
3 Data & Model
3.1 Data
I use monthly data taken from the Orga-
nization for Economic Co-operation and De-
velopment (OECD) and Federal Reserve Eco-
nomic Data (FRED) for Denmark from 1990
to 20162 . The OECD defines itself as a forum
of countries committed to democracy and the
market economy, providing a setting to com-
pare policy experiences, seek answers to com-
mon problems, identify good practices, and
co-ordinate domestic and international poli-
cies3 . Whereas the FRED is a database main-
tained by the Research division of the Federal
Reserve Bank of St. Louis.
Since all the original data is in monthly form
there is no need for interpolation as would be
needed with quarterly data.
Figure 1.
Two important aspects with regard to
time series modelling should be carefully re-
viewed. The first is seasonal adjustment. Sea-
sonal changes can be visualized by a box-plot
across months (figure 1.) will give us a sense
on the seasonal effect. Not surprisingly there
seems to be little seasonal effect, besides some
months with increased outliers. Second, is
stationary for a constant mean. Figure 2 vi-
sualizes the comparison between inflation tP
and the first difference tP .
 no surprise that the breus-godfrey test rejects
no serial correlation of the 12th lag term (ap-
pendix F). However, including this term into
our model did not resolve this matter, so I left
it out. No further adjustments are needed.

4 Results
The results of our model are given below in
Figure 2. table 1
Notice that the first differences is indeed
more stationary. The Dickey-Fuller test in ap- Table 1: Model outputs
pendix B gives statistical proof for stationary. Constant -0.007
Therefore performing a regression on tP is (0.071)
preferred. Notice, that this is simply includ- Inflation(-1) 0.919***
P (0.022)
ing the lagged inflation t1 to the regression
P Unempl-nairu -0.039**
on t , which is in line with the theory (see
previous section). (0.015)
Unempl(-12) - nairu(-12) 0.041**
(0.02)
3.2 Model Unempl(-24) - nairu(-24) -0.038**
The model that will be used is based on the (0.015)
last equation (4) from section 2.1. The regres- Brent oil price 0.019***
sors in Xt consist of: crude oil price (brent), (0.003)
and the 10 year yield. Concerning the nairu, Brent oil price(-1) -0.017***
since it is an estimation in itself, it has to (0.003)
estimated first. Appendix C. describes the 10-year bond yield 0.025**
method used in this paper. The final model (0.011)
is: R-squared 0.914
Akaike -0.071
tP = + t1 P
+ 1 (ut unt )+ No. observations
2 (ut12 unt12 ) + 3 (ut24 unt24 )+ (after adjustments) 288
1 xt;brent + 2 xt1;brent + 3 xt;longterm + Standard errors are reported in parentheses. *,
**, *** indicates significance at the 90%, 95%,
4 xt;laborcost + t (5)
and 99% level, respectively.
The Jarque-Bera test for normality of the
standard errors does not reject the joint zero- The first observation that can be made is
hypothesis of zero skewness and zero kurtosis that the constant is highly non-significant (it
(appendix D). Therefore we can assume nor- actually had a p-value of 0.919). This would
mality. Testing for heteroskedacticity did not suggest that if there is no inflation, no unem-
reject the zero-hypothesis of constant vari- ployment, etc..., then inflation is zero. Which
ance (appendix E). If one has looked at the seems like a reasonable assumption. Further-
acf plot in appendix B, then it will come to more we see that the lagged term for inflation
(0.919%) is highly significant4 . This suggests
that inflation from a previous month has a
major impact on the inflation in the current
month. An explanation for this would be that
consumers expectations of coming inflation
depends on previous inflation, which is in line
with the results of Forsells & Kenny (2002).
As expected is the effect of unemployment
negative (-0.039%). However, notice that the
12th lagg term is positive and the 24th lagg
term is negative again. An explanation for
this could be that previous unemployment
rates, although significant, cancel each other
out and therefore neutralizes the downward
effect of unemployment on inflation. This
seems to be vice versa for oil. As expected
does the 10-year bond yield have a significant
effect (0.025%).
4
A one-percent change in inflation(-1), unemployment or 10-year bond yield accounts for a i percent
change in inflation. Whereas for brent a one-unit increase accounts for a i percent change.
5 Conclusion
I used monthly data from Denmark between
1990 and 2015 to examine the relation be-
tween inflation and unemployment, or more
widely known as the Philips-curve. I found a
relative simplistic model for explaining infla-
tion by introducing two shock effects; oil and
10-year bond yield. Although a more complex
relation has been found, Philips findings of
the negative effect of unemployment on infla-
tion still holds. Since the goal of this paper
was to find a relative simplistic equation for
explaining inflation, further research can be
done by including more indicators; For exam-
ple, 3-month yield, gdp, import prices. An-
other adjustment could be to evaluate multi-
ple time-periods separately.
In general, explaining inflation brings still a
lot of uncertainty. Therefore, further research
is still required.
References
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changes on Spanish and euro area consumer price inflation. Economic Modelling, 28(1),
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[2] Bagus, P., Howden, D., Gabriel, A. (2014). Causes and consequences of inflation. Business
and Society Review, 119(4), 497-517.

[3] Batini, N., Jackson, B., Nickell, S. (2005). An open-economy new Keynesian Phillips
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[4] Estrella, A., Mishkin, F. S. (1996). The yield curve as a predictor of US recessions.

[5] Forsells, M., Kenny, G. (2002). The rationality of consumers inflation expectations:
survey-based evidence for the euro area. ISO 690

[6] Gal, J., 2011, The return of the wage Phillips curve, Journal of the European Economic
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[7] Hoover, K. D. (2008). Phillips Curve. The Concise Encyclopedia of Economics.

[8] Kaya, H. (2014). Does the level of the yield curve predict inflation?. Applied Economics
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[9] Mankiw, N. G. (2012). Macroeconomics 5th ed.

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Appendix
A Descriptive statistics

Variable (type) Retrieved fromAdjustment min 1st QrtMedian Mean 3rth Qrt. max
Inflation (%) OECD - -0.101 1.523 2.078 1.98 2.462 4.388
Unemployment (%) OECD - 3.1 4.8 6 6.071 7.4 9.9
Brent oil price (level) FRED seasonally 9.82 19.065 29.805 47.737 72.575 132.72
10-year government
bond yield (%) FRED seasonally 0.2 3.435 4.55 5.012 6.645 11.310
No. observations 312

B Stationary
The acf plot of the first lagged difference q show that there are few significant lags, except
where Lag = 12.

Performing the Augmented Dickey-Fuller test with H0 : non-stationary and H1 : stationary.

Gives the following output:

Dickey-Fuller = -6.9293,Lag order = 6,p-value = 0.01.

Hence, we can reject the zero-hypothesis of non-stationary.

C Estimating the NAIRU

The nairu is an external shock that influences the unemployment effect on inflation. Cap-
turing the nairu and abstracting it from the unemployment rate gives the persistence of the
unemployment effect. The persistence of the unemployment effect. A widely used method for
capturing the nairu is to perform a rolling regression for tP on the unemployment terms.
In this paper the rolling regression is performed in eviews for several window sizes. The
mathematical definition is as follows:
tP = ut ut1 ut2 + vt (6)

When inflation is staying constant then tP = 0, so un = . Since in our case the
++
yearly nairu is estimated, interpolation is needed. However, take in account that interpolating
yearly data to monthly introduces a bias.

From the above figure we can see that the that the estimated nairu captures the nairu
from the OECD, although it has a some extreme points. The trend line gives a better
representation, but is still biased.

D Normality of standard errors

E Heteroskedacticity

H0 : constant variance

F Serial correlation

H0 : no serial correlation