Inflation determination in Ireland
Abstract
Paul Egan (BA, Msc) and Anthony Leddin (BA, Msc, PhD)
University of Limerick, Ireland
June 2013
National Wage Agreements (NWA’s) between the social partners (government, trade unions and employer representatives) were introduced in Ireland in January 1988 and were terminated in 2008. The economic crash in 2008, due largely to the collapse of the building and construction sector and the banking crisis, resulted in a significant fiscal deficit and the government had little choice but to renege on the agreed pay award. This ended the partnership agreements. By 2008, there were in total seven successive agreements spanning a twenty-one year period.
This paper uses the wage agreements to construct a new wage-inflation price index for both the public and private sectors. These indexes show how a worker would have fared if his or her salary was wholly determined by the pay awards over the period. The main objective of the paper is to examine the inter-relationship between wages, unemployment and inflation in Ireland. Of particular concern, is the role of domestic factors in the inflation process and the decline in price competitiveness over the last decade.
The approach is to estimate both the New Keynesian Phillips Curve (NKPC) and the Triangle Phillips Curve (TPC) models using the public sector pay award index as the dependent variable. The NKPC model is based on forward-looking inflation expectations whereas the TPC model emphasises inertia and persistence effects and allows for supply-side shocks.
In order to fully capture any non-linearities in the Irish data, we use the Markov Switching model of Hamilton (1989). The Markov switching model, also known as the regime switching model, is one of the most popular nonlinear time series models in the economic literature. This model involves multiple structures (equations) that can characterize the time series behaviour in different regimes. By permitting switching between these structures, this model is able to capture more complex dynamic patterns.
The estimation of the Markov switching model depends on maximum likelihood. The maximization of the likelihood function of the model requires an iterative estimation technique to obtain estimates of the parameters of the model and the transition probabilities. With the parameters identified, it is then possible to estimate the probability that the variable of interest, in this case wage inflation, is following a particular regime.