Output-inflation tradeoffs in 34 countries

J ECO BUSN 1986; 38:353-360

353

Output-Inflation Tradeoffs in 34 Countries John T. Addison, Henry W. Chappell, Jr., and Alberto C. Castro

This article examines the responsiveness of real output to the variability of inflation and aggregate demand. In the manner of Lucas (1973), estimates of the output-inflation tradeoff are computed for a large sample of countries. This measure is then correlated with the variances of the inflation rate and the growth rate in nominal income. Because differences in inflation variance (and hence the tradeof0 are viewed as the outcomes of differences in demand variance, correlations between these two variables are also reported. Cross-time and cross-country results provide a good measure of support for Lucas and the notion that attempts to exploit the tradeoff weaken it.

I. Introduction This article provides some new international evidence on output-inflation tradeoffs in a framework first set by Robert Lucas (1973). In this new classic view, the existence of a tradeoff between output and inflation is conditional on unanticipated inflation. If movements in the general price level are mistakenly perceived to indicate changes in relative prices, then economic agents will alter their behavior in a manner that produces fluctuations in real output and employment around their "natural" levels. Once agents discover that price changes are quite general and not market specific, each real variable will return to its previous level due to homogeneity of degree zero of all supply functions. More concretely, this equilibrium model implies that the real output response will be inversely related to the variability of inflation and aggregate demand. Economic agents in a high-variance environment will detect that observed price movements primarily reflect general price effects. As a result, the terms of the output-inflation tradeoff should weaken. The Lucas model also predicts an inverse association between the variance of the growth rate in nominal income or aggregate demand and the terms of the tradeoff, coupled with a positive association between the variance of the growth rate in nominal income and the variance of the inflation rate. For empirical purposes, we employ a modified version of the Lucas model, first tested by Froyen and Wand (1980) for a sample often industrialized nations. In extending the sample to some 34 countries, we find a reasonable measure of support for all three implications of the Lucas model noted earlier, as opposed to Froyen and Waud, who reported only one We acknowledge able research assistance from Pedro Portugal and helpful comments from two anonymous referees. Addison and Chappell are from the Department of Economics, University of South Carolina, Castro is from the University of Porto, Portugal. Address reprint requests to John T. Addison, University of South Carolina, College of Business Adminstration, Department of Economics, Columbia, South Carolina 29208.

of Economics and Business @ 1986 Temple University

Journal

0148-6195/86/$03,50

354

J.T. Addison, H. W. Chappell, Jr., and A. C. Castro significant correlation (that between inflation variance and the terms of the output-inflation tradeoff.) As we shall see, however, our generally more favorable results owe much to the inclusion of less developed countries (LDCs) in our sample. By including more countries in varying stages of development, we run the risk of violating the assumption that several parameters of the underlying model are relatively stable across countries (Lucas 1973, p. 330). But Lucas' results rely heavily on the volatility of two developing nations in his sample (Argentina and Paraguay). That said, the intracountry comparisons we present are undisturbed by this problem and again yield a good measure of support for Lucas.

II. The Model Our model, following Froyen and Wand (1980), is based on a theoretical modification of the Lucas treatment suggested by Cukierman and Wachtel (1979). ~ But, as in Lucas, the basic problem faced by economic agents is again one of extracting relative price movements from aggregate price changes. In testable form, the modified Lucas model may be written: Yct= Ot+ TrAxt + )~Yc,t- l ,

(1)

where Yct is the residual ( Y t -- Y n t ) from the trend line Ynt = a + bt, Yt being the log of real GNP; Art is the change in the log of nominal GNP, xt; the parameter Ir charts the degree of responsiveness of real output to nominal aggregate demand shocks; and the parameter ~ is a speed of adjustment coefficient. The aggregate demand shocks are considered exogenous and are assumed to follow a normal distribution, with mean ~ and variance 02. Market-specific demand shocks are taken to be independent of aggregate shocks, and their distribution is assumed normal, with mean zero and variance a 2 and identical across markets. Returning to Equation (1), 7r is given by: 3'

~"=

,

(2)

(Ox2/O~) + (1 + 3') where 3' indicates the response of supply to an unanticipated price change, and o 2 and o 2 are the variances of market-specific and aggregate demand shocks, respectively. Thus, for fixed values of 3" and 02w, as Ox2 tends to infinity, 7r tends to zero. The variance of the aggregate price level, o 2, may be writter. 2 a 2=

ax

(3)

(1 +03') 2 ' where 8 = [a~/(a2x + a2~)]. Our preceding discussion was couched in terms of the variance of the inflation rate, oo2. ao2, however, is simply 2a 2, and so, given fixed values of 3' and g 2W~ the variance of the inflation rate is a monotonically increasing function of the variance of the nominal aggregate demand shock. This brings out the causal sequence suggested by Lucas

t The modification introduces individual equilibrium conditions for each of the markets such that the variance of relative prices is not a constant but, rather, varies directly with the variance of the aggregate price level. In testable form, the model retains the lagged term in real output (i.e., a lagged response in the aggregate supply curve) after Lucas.

Output Inflation Tradeoffs

355

whereby differences in inflation variance and consequently in 7r are the outcome of differences in aggregate demand variance. 2 If we assume that 3' and a w are relatively stable across countries, then we obtain from equations (2) and (3) the following predictions described earlier: 1. 7r, the output-inflation tradeoff, should be inversely related to o 2 and hence a2; 2. 7r should be negatively related to a X2"~ and 3. ~x2 and ep2 should be positively related. Note, finally, that no allowance is made for supply shocks in the model tested here. Cyclical movements in real output result primarily from nominal demand shifts; supply shocks have no systematic role, merely entering Equation (1) through the error term. In addition, no account is taken of the degree of "openness" of the particular economy. 2

III. Findings Our analysis makes use of a sample of 34 countries for which annual (IMF) data were available on a consistent basis for the period 1953-1980.3 Computed values of 7r, opz, and trX2 are reported in Table 1 for both the total period and the two subperiods 1955-1966 and 19671980. The latter follow the splits chosen by Froyen and Wand (1980) for much of their empirical analysis. 4 For each country, Equation (1) was estimated for the entire period and each of the subperiods. In this exercise, real output was detrended separately for each subperiod rather than by applying the results of the whole period and detrending to each of the subperiods. The results of our tests of the Lucas model are summarized in Tables 2 and 3 for the crosscountry and cross-time comparisons, respectively. Tables 4 and 5 present corresponding calculations for LDCs and developed countries. 5

A . The Cross-Country Evidence r and a 2 ShouM be Negatively Correlated. Froyen and Waud (1980) report that this correlation, though always negative, was significantly so for the second subperiod alone and then only at the 10% level. For our larger sample of countries, however, this correlation is significantly negative at the 5 % level or better for both the entire period and for each of the subperiods. When the sample is divided into LDCs and developed countries, a mixed pattern emerges. Although all correlations are of the expected sign, only those for LDCs are significant at conventional levels.

2 Parkin, Bentley, and Fader (1981) have shown that if the analysis is pursued in an open-economycontext, then different exchange-rate regimes may affect all three predictions of the model. 3 Alberro's (1981) study has an even wider sample of countries than is employed here. His tests are, however, like those of Lucas, restricted to estimating the relationship between 7r and 02. 4 Froyen and Waud (1980) devised several ways of splitting their sample period but report similar results for each method. 5 Of the 34 countries listed in Table 1, the following were classified as LDCs: Colomb'~a.Ecuador, Greece. Guatemala, Honduras, Korea, Mexico, Panama, Paraguay, Portugal, Sri Lanka, Thailand, Turkey, and Venezuela.

Australia Austria Belgium Canada Colombia Denmark Ecuador Finland France Germany Greece Guatemala Honduras Iceland

Country

.039 .586" .518" .362" .058 .571 `" .349 ° .335" - .224 .653 `" .017 .144" .270" .064

r

ax, 2

.002036 .000337 .000862 .001278 .004254 .000875 .005677 .001796 .001115 .000513 .003855 .003090 .001561 .013787

°2p .001617 .000692 .001031 .001907 .004374 .000945 .007173 .001420 .000594 .001708 .002946 .003716 .002756 .013969

°2x

1955-1980,

Whole Period: 1955-1980

T a b l e 1. E s t i m a t e s o f 7r, o~, a n d

.391`" .601" .623" .701" - .037 .509 ° .691 .754" - . 159 .562`" .406" .660 ° .900" .589"

71-

1955-1966,

.000692 .000145 .000291 .000127 .002842 .000455 .002726 .000622 .000804 .000636 .001334 .000359 .000225 .001153

°2p,

1955-1966

.000968 .000708 .000640 .001189 .002615 .000949 .001032 .000409 .000580 .002598 .001839 .000774 .001800 .002455

°2x .047 .740" .870" .487" .039 .900 ~ .285 .537" - .022 .801 `" - .010 .110 .303 .122

Subperiods

1967-1980, Annual Data

.001786 .000372 .000801 .001077 .003845 .000407 .006231 .001833 .000875 .000350 .004145 .003691 .001708 .014728

O-2 p

1967-1980

.001271 .000678 .000848 .001624 .003577 .000480 .006607 .001762 .000589 .000804 .002543 .003959 .002196 .016302

O-2 x

call

-

.177 a - . 114 ~ - .035 .562 ° .158 ° .010 .588 ° .010 .172 .260 ° .056 .067 .267 ° - .023 .914 a .157 ° .069 - .091 .463 ° -.031

.002923 .038000 .003423 .001302 .009328 .007077 .000647 .002000 .002080 .006140 .005119 .002999 .004150 .001073 .000629 .002935 .025285 .003103 .000608 .007128

.003793 .030849 .002667 .001709 .009694 .006893 .001124 .001798 .002068 .007537 .004845 .003024 .005944 .000626 .001138 .003900 .022342 .002218 .000875 .006146

.527 ° .451 .839 ~ .480 ° .066 .428 ° .537 ° .016 .643 ° .040 .544 ° .573 ° .555 ° .532 ~ .688 ° .596 ° .212 ° .908 ° .867 ~ .434 °

Source: IMF Yearbook o f International Financial Statistics, various issues. Significant at the 5% level or better.

Ireland Israel Italy Japan Korea Mexico Netherlands Norway Panama Paraguay Portugal South Africa Sri L a n k a Sweden Switzerland Thailand Turkey UK USA Venezuela

.000578 .000611 .000500 .000587 ~018084 .000480 .000456 .002228 .000223 .007506 .000250 .000122 .000581 .000337 .000405 .000692 .003439 .000213 .000061 .001169

.000954 .002023 .000815 .001879 .018880 .000847 .001284 .001832 .001021 .007666 .000564 .0004I 3 .001274 .000233 .000558 .002154 .005703 .000188 .000822 .001596

- .024 - .095 .011 .509 a .505 - .006 .653 a - .049 .163 .248 ° .035 .120 .128 .208 .732 ° .001 - .128 a - .037 .680 a -.028

.000378 .009563

.003995

.000705 .003962 .036484

.002236 .054682 .003756 .001581 .001795 .007272 .000455 .001024 .002508 .004738 .005063 .002659 .004501 .000963

.002076 .046651 .003078 .001585 .001664 .006693 .000823 .000936 .002178 .008236 .004120 .003047 .005427 .000657 .001608 .004244 .027595 .002225 .000390 .008829

U¢I

o

,-1

5

O

358

J. T. A d d i s o n , H. W . ChappeU, Jr., and A. C. C a s t r o T a b l e 2. Correlations A m o n g E s t i m a t e s o f ~', a 2, and a2x A c r o s s Countries: 1 9 5 5 - 1 9 8 0 , 1 9 5 5 1966, and 1 9 6 7 - 1 9 8 0 Whole Period ~

Subperiod o

Correlation

1955-1980

1955-1966

1967-1980

~, a D2 a~ o x2~ a p2

-.42040 -.38526 .99014

-.50429 -.46777 .97455

--.40756 -.39608 .99115

a Significant at the 5% level or better.

Table 3. C o r r e l a t i o n s A m o n g E s t i m a t e s o f 7r, a 2, and °2x L D C s ( N =

14) and D e v e l o p e d

C o u n t r i e s ( N = 20) Whole Period (1955-1980)

Subperiod

Correlation r , 02o r , o~ a p~ 2 a x2

1955 - 1966 -"49697° -.35736 .98525 b

(-"39036a) (-.35657) ( .99463 b)

-"62541b -.60975 b .98235 b

1967-1980

(-'64229b) (-.23666) ( .50888 b)

-"52580~ .48730 ~ .98180 b

(-'38076~) (-.36919) ( .99656 b)

Developed country correlations are given in parenthesis. a Significant at the 10% level. b Significant at the 5% level or better.

Table 4. C o r r e l a t i o n s A m o n g C h a n g e s in r ,

0 .2

p~

and

0 .2

X

B e t w e e n the Subperiods 1 9 5 5 - 1 9 6 6 and

1967-1980 Alr, Aap2 ATr, z~a~ Ao~, Aa~

-.37720 ~ -.39647 ° .98653 ~

Significant at the 5% level or better.

2. L D C s and D e v e l o p e d C o u n t r i e s T a b l e 5. C o r r e l a t i o n s A m o n g C h a n g e s in ~', a 2, and a x. ,~r, Aap2 ATr, na2x Aap2, Ao~ o Significant at the 10% level. 0 Significant at the 5% level or better.

--.47962" -- .53531 b .96577 b

(--.33839) ( -- .34953) ( .99680 b)

Output Inflation Tradeoffs

359

o2 and o~ Should be Postively Correlated. Froyen and Waud (1980) report a significant positive correlation between these variables (at the 1% level) for the sample period as a whole. This overall result was apparently produced by the strong correlation observed in the second subperiod, however--for the first subperiod the correlation was not significant at the 10% level. For our larger sample of countries, Ox 2 and Op 2 are highly correlated and the correlation is significant at the 1% level or better in all periods. Significant positive correlations are also observed for both the LDCs (at the 1% level) and developed countries (at the 5% level). lr and %2 Should be Negatively Correlated. This hypothesis is strongly supported by both Froyen and Wand's (1980) results and our own for the total sample of countries. Significant correlations are also found for the LDCs and developed countries, although, as before, the correlations are generally weaker for the latter.

B. The Cross-Time Evidence The Lucas model also suggests tests based on intracountry comparisons through time. Thus, one would expect the output-inflation tradeoff to have deteriorated in those countries for which %2 and a~ increased from 1955-1966 to 1967-1980. A comparison of the estimates given in Table 1 reveals that for the 29 countries for which ap2 and ex2 changed in the same direction, the estimate of 7r changed in the opposite direction in 25 of them. And in the I0 cases in which the estimate of r changed significantly (at the 5 % level) across the two subperiods, a~ and ax2 changed inversely nine times. Table 4 summarizes the cross-country correlations for changes in a~, °2x, and r across the two subperiods. All correlations are significant at the 5 % level, and the results are considerably stronger than those reported by Froyen and Wand (1980, pp. 416-417). Corresponding changes in pairs of variables for the sample of LDCs and developed countries are given in Table 5. All the results are of the expected sign, but only those for the LDCs are consistently significant.

IV. Interpretation The strength of our results, compar~ with those of Froyen and Waud (1980), can largely be explained by the nature of the sample. Using 34 rather than only 10 countries produces considerably more variation in the values of o~ and op2. Using the Froyen-Waud sample, the cross-country sample variance in individual country values of o~ is 1.10 x 10-6; in our extended sample it is 5.56 × 10- 5. Similarly, the cross-country variance in values of Ox 2 is 4.3 x 10 -7 for smaller sample as compared with 3.9 x 10 -s in the larger sample. With greater variation in ax2 and a~ and a stronger correlation between them, detecting the hypothesized corresponding variations in ~- is easier. The sample of LDCs contributes importantly to the results. Considerably greater variance in inflation and nominal aggregate demand exists within this sample. Adding the developed countries provides additional variance. Clearly, the terms of the tradeoff are markedly inferior

360

J.T. Addison, H. W. Chappell, Jr., and A. C. Castro in the LDCs, reflecting their very considerably higher aggregate inflation variance and aggregate demand variance. 6 We conclude, therefore, that the international data assembled here provide a broad measure of support for the Lucas natural-rate model. Using simple test procedures that abstract from aggregate supply disturbances, we found that differences in aggregate demand variance produce systematic variations in the terms of the tradeoff and the variance of the inflation rate both across countries and within countries across subperiods. This is not to deny that explanations other than Lucas's exist for the correlations reported here (e.g., devolving around the assumed exogeneity of Art), merely that our findings offer support to a number of strands of the natural-rate hypothesis.

References Alberro, J. March 1981. The Lucas hypothesis on the Phillips curve--Further international evidence. Journal o f Monetary Economics 7:239-250. Cukierman, A., and Wachtel, P. Sept. 1979. Differential inflationary expectations and the variability of the rate of inflation: Theory and evidence. American Economic Review 69:595609. Froyen, R. T., and Waud, R. N. June 1980. Further international evidence on output-inflation tradeoffs. American Economic Review 70:409-421. Lucas, R. E. June 1973. Some international evidence on output-inflation tradeoffs. American Economic Review 63:326-334. Parkin, M., Bentley, B., and Fader, C. 1981. Some international evidence on output inflation tradeoffs: A reappraisal. In Development in an Inflationary World (J. Flanders, ed.). New York: Academic Press. 6 The means (and standard deviations) of ~', 02p ' and 02x for LDCs and DCs for the whole period and subperiods are as follows: LDCs

1955-1980

1955-1960

1967-1980

~r oa2 a2 r 02 o~ ,r 02 a~

.130 .006263 .006452 .440 .002851 .003412 .118 .006824 .006297

DCs (. 127) (.005890) (.005048) (.277) (.004815) (.004890) (. 169) (.008792) (.006541)

.271 .003965 .003685 .549. .000551 .001075 .360 .004698 .004372

(.322) (.008518) (.007013) (.255) (.000477) (.000718) (.361) (.012177) (.010525)