Regional Inflation Persistence Analysis: A Case Study In .
Advances in Economics, Business and Management Research, volume 14423rd Asian Forum of Business Education(AFBE 2019)Regional Inflation Persistence Analysis:A Case Study in SurabayaLia Umi Farida1*, Munawar Ismail2, David Kaluge21Master degree in Faculty of Economics and Bussiness, University of Brawijaya, IndonesiaSenior lecturer in Faculty of Economics and Bussiness, University of Brawijaya, Indonesia*Corresponding author. Email:liafarida11@gmail.com2ABSTRACTThis study aims to determine the behavior of regional inflation in Surabaya by looking at its persistence, namelythe speed of inflation returns to its equilibrium after a shock. Using monthly data on general inflation, commoditygroups and commodity goods and services, then the persistency is calculated utilizing Autoregressive Method.Furthermore, inflation cause is estimated by NKPC Hybrid Model. The results showed that the general inflationin Surabaya tends to be persistent as evidenced by the persistence value of 0.98. Whereas commodities with highpersistence value are dominated by commodities of volatile food and administered prices.Meanwhile, the cause ofthe high inflation persistence in Surabaya is produced by a combination of backward-looking inflationexpectations and dominated by forward looking inflation expectations.Keywords: Surabaya, Persistence, Inflation, Commodity Groups, Goods, Services, hybrid NKPC1. INTRODUCTIONInflation control is important to do because low and stableinflation is an effort to realize the welfare of society. Inflationin a region will affect the economic growth of the regionconcerned, because it’s stability will affect the certainty ofbusiness and investment. Thus, low and stable inflation in thelong term will support sustainable economic growth. Inflationthat is too low even to the level of deflation will suppresseconomic growth. Similarly, the too high of it will reduce thepurchasing ability of the people so that it inhibits the wheels ofthe economy.Many studies have been conducted on the inflation persistencebefore. On the European Continent, it takes more than 1 yearfor monetary policy to have the maximum effect on inflation[1]and there is a tradeoff between inflation persistence andflexibility of inflation assumptions in the long run [2]. InIndonesia, inflation persistence is quite high when using asample from 1990 to 2006. However, if the crisis period during1998 - 1999 is controlled, inflation in Indonesia tends to havelow persistence [3]. Meanwhile, the average inflationpersistence of various regions in Indonesia is relatively high,including in DKI Jakarta Province [4], North Sumatera [5],Central Java [6], and West Papua [7].Various studies previously conducted above show that generalinflation persistence in Indonesia is remaining high. Thenational inflation is formed by almost 81% of regional inflation(outside Jakarta), so this research will focus on one of theregions at the Regency / City level, namely Surabaya City.Surabaya City is the Capital City of East Java Province whichis one of the regions that does not form a Regional InflationControl Team (TPID). Through interviews in the media,Surabaya major Tri Rismaharini stated that the formation of theTPID will only add to the budget burden, so that the function ofregional inflation control activities is directly within therelevant agencies. On the other hand, over the past 10 years thecity of Surabaya has the highest average inflation compared toother CPI districts / cities in East Java [8].The average inflation in Surabaya is the highest compared toother regions in East Java[8]. This could be because theposition of the City of Surabaya is the provincial capital whichis the center of economic activity in the province of East Java.From 2006 to 2018, inflation in the city of Surabaya is often ina highest position in East Java Province. In addition, the city ofSurabaya has the second highest city inflation weight inIndonesia after DKI Jakarta based on the 2012 Cost of LivingSurvey as mentioned in [9].Based on some of the reasons mentioned above, it is importantto research how inflation behavior in the city of Surabaya bylooking at the persistence of inflationand its causes. Theimportance of a study of persistence at the district / city level isbecause each region has different inflation characteristics, so itCopyright 2020 The Authors. Published by Atlantis Press SARL.This is an open access article distributed under the CC BY-NC 4.0 license -http://creativecommons.org/licenses/by-nc/4.0/. 344
Advances in Economics, Business and Management Research, volume 144is necessary for each region to be well acquainted with theinflation behavior in the region. This is done to support theregion concerned so that it can take more effective and targetedpolicy measures in accordance with the characteristics andbehavior of inflation in the region.2. LITERATURE REVIEW2.1. Persistence of InflationMarques[2]defines inflation persistence as the speed ofinflation to return to its equilibrium level after the onset ofshock. While Angeloni[10]defines inflation persistence as atendency to slow the movement of inflation toward its longterm value when there is a shock in the economy. A similardefinition is also stated by Willis in [11] which defines inflationpersistence as the time needed for inflation to return to baselineafter a shock. Inflation persistence is a long-term effect ofshocks on inflation. Therefore, inflation persistence is fast orslow inflation to return to its natural value when there is ashock.The high degree of inflation persistence indicates the slow rateof inflation returning to its natural level. Conversely a lowdegree of persistence indicates the rapid rate of inflation toreturn to its natural level. Shock referred to include governmentpolicies, distribution disruptions, natural disasters, and weatherchanges. Studies on inflation persistence are important toimprove the ability to forecast inflation, obtain clarity of thedynamic effects of exogenous price shocks, provideinformation / guidance and improve monetary policy, and toassess whether different monetary policy regimes will producedifferent persistence [11].Batini[1]provides a more detailed explanation by distinguishing3 types of inflation persistence. The first type is positive serialcorrelation in inflation. Second is the time lag betweensystematic monetary policy action and its effect on inflation.Third is the slow response from inflation to an unsystematicmonetary policy. The first type of persistence is a reduced formof inflation that simultaneously manifests the underlying pricesetting process, the implementation of monetary policy, and theprocess of establishing price-setting expectations. Changes inone of these three factors will affect the nature of inflationautocorrelation. However, various studies show that persistencemeasured by this definition tends to decrease over time,especially after the onset of a monetary regime with strong antiinflation credential.Type 2 inflation persistence refers to the number of periodsneeded to make changes in monetary policy in order to have amaximum effect on inflation. Batini and Nelson [12] examinethe time lag between monetary policy actions and the inflationresponse using UK and US data in the period 1953-2001 onrates of monetary growth, inflation and interest rates, as well asannual data on money growth and inflation. They assert that ittakes more than a year before the monetary policy taken has apeak effect on inflation both in the US and in the UK eventhough there have been many changes in monetary policysettings in both countries.Type 3 of inflation persistence is related to the amount of delayneeded for inflation to respond to policy shocks. This type ofpersistence is often the only one that economic modelersconsult when validating a model dealing with the dynamics ofthe process of making data in the real world. In conclusion, asdiscussed in Batini and Nelson [12], type 2 inflation persistenceis the most relevant type for monetary policy making becausethis type of persistence determines the cost of disinflation.Knowing the lag between policy action and its peak effect oninflation informs monetary policy makers about how early theyshould be when responding to private sector shocks by helpingto minimize the variability gap in output costs from pricestabilization.2.2. Causes of Inflation PersistenceThe cause of inflation persistence can be seen through the NewKeynesian Phillips Curve (NKPC) equation which was built byGali and Gatler in [18]. Maical [13]argues that the developmentof the Hybrid NKPC model begins with the Phillips curvewhich is an empirical study by Phillips [14]of the Britisheconomy in 1861 – 1957.He found a decrease in theunemployment rate (or an increase in output growth) would befollowed by an increase in inflation. Research by [15]and[16]argue that the tradeoff between the inflation rate and theunemployment rate will only occur in the short term. Whereasin the long term, the tradeoff will not happen because theunemployment rate tends to be at its natural level, so theprevailing monetary policy will only affect the inflation rate.Empirical facts that support the opinion of Friedman andPhelps are stagflation experienced by industrialized countries inthe 1970s. This stagflation is at the same time the cause of thecollapse of the Phillips curve in the 1970s and 1980s[17].In the latest macroeconomic model developed by NewKeynesian economists, the Phillips curve now shows a positivecorrelation between the inflation rate and the output level (Galiand Gertler). The relationship between the inflation rate and theoutput level is then called the New Keynesian Phillips Curve(NKPC).Furthermore, the New Keynesian Phillips Curvemodel has received some criticism which shows that the modelis not optimal for analyzing the phenomena of the Phillipscurve. Related to these criticisms, Gali and Gatler [18]developed a hybrid model of the New Keynesian PhillipsCurve, a model that includes the effect of inflation lags byentering the backward looking inflation rate as a rule of thumbin determining prices.Constructing and estimating the structural model of the HybridNew Keynesian Phillips Curve, Gali and Gertler included thereal marginal cost variable to measure the impact of increasedproductivity from inflation proxy by the output gap and thedivision of labor income. It also included elements of backwardlooking and forward looking expectation. The results obtainedfrom this study indicate that the New Phillips Curve model345
Advances in Economics, Business and Management Research, volume 144containing forward looking elements is able to explain thedynamics of inflation (dominant).Based on the explanation above, the causes of inflationpersistence according to the New Keynesian Phillips Curvehybrid model, are as follows:1. Extrinsic persistence associated with persistence inmarginal costs or output gaps2. Intrinsic persistence related to inflation dependencies onprevious period inflation (backward looking expectation)3. Expectations-based persistence related to the formation ofinflation expectations based on forward looking conditionsAccording to Andrews and Chen [20], the method of addingcoefficients is the best way to measure the persistence scale.Inflation persistence is said to be high if the current inflationrate is strongly influenced by the lag value, so the coefficient isclose to 1. In this case, inflation is said to be close to the unitroot process. In line with this Dosschee&Everaert[21] statesthat if the value of ρ 0.5 then inflation has low persistence.For estimation ρ, determine the appropriate number ofdependent variable lag using Akaike Information Criterion(AIC) and or Schwarz Bayesian Information Criterion (SBIC).Meanwhile, to find out how long it takes for inflation to returnto the initial balance or its natural value after the shock [16] :4. Error term persistence due to the effect of supply sideshock or inflation shock that occurs.(3)3. METHODSInflation persistence is estimated using the univariateautoregressive (AR) time series model analysis method.Autoregressive is a model that includes the lag of the dependentvariable as an independent variable [19]. The choice of the ARmodel is because the AR model is a fairly good measure ofinflation persistence [2]. With the AR model, the level ofinflation persistence is measured from the sum of thecoefficients of the dependent variable lag. From several studiesthat have been carried out, such as those of [2],[3],[4], theunivariate autoregressive (AR) time series model is the mostprevalent approach in empirical research. The AR formula withthe order ρ can be described as follows:General Autoregressive Model:.(1)Or it can be written as:Where : monthly inflation rate at time tconstants from the results of the estimationprocess, as a control - on average inflationnumber of AR coefficients random error term or residualFrom the estimation results of the equation, the inflationpersistence level is calculated by adding up the AR coefficientas follows:Where h is the time needed for inflation to absorb 50% of theshock that occurs before returning to its average value and ρ isthe result of an estimated degree of inflation persistence.To see the causes of inflation persistence, the New KeynesianPhillips Curve hybrid model by Gali and Gatler[18] is used asfollows:Note : Inflation on time periodt ;Inflation in the past t-1(backward looking);Inflation expectations on timet 1with time conditions t (forward looking);Output Gap;Error term;CoefficientThe Model will then be estimated using the Ordinary LeastSquare (OLS) method. To get the BLUE (Best LinearUnlimited Estimator) of estimation results, it is necessary to doa classic assumption test which includes Normality,Autocorrelation, Heteroscedasticity, and Multicollinearity Tests[22].Meanwhile, to determine the inflation expectationvariable in the NKPC hybrid equation, it is done by predictingor forecasting inflation using the AR Forecasting method. Thisis done because the city of Surabaya has no inflation target ortarget that can be used to describe inflation expectations. Thereason for the use of AR Forecasting is that Surabaya Cityinflation is still adaptive, that is, inflation that is formed basedon observed inflation or follows the previous inflation.The output gap variable is obtained by calculating thedifference between the actual output and its potential output.Potential output is the maximum amount of goods and servicesthat an economy can produce in the most efficient condition.Potential output is the level of output that is consistent withinflation statistics and to calculate the method the HodrickPrescott Filter is used. HP filters are used to find potential GDPtrends based on actual GDP data. This technique minimizessize combinations around potential GDP trend fluctuations andthe rate of change in GDP trends for the entire sample. Theoutput gap shows the degree of tightness and slackness ofaggregate demand and supply. This indicator is used to assesspressure on price changes.j.(2)346
Advances in Economics, Business and Management Research, volume 1444. RESULT AND DISCUSSIONThe measurement of the degree of persistence of inflation inSurabaya is carried out on the General Inflation variable, thevariable in the CPI Spending Group, as well as the variable incommodity goods and services. Commodities of goods andservices are chosen based on the average of the largestinflationary contributions during the study period, then the 20biggest contributors to inflation in the period were taken. Thedata used in this study are secondary data obtained from thepublication of the Central Statistics Agency and BankIndonesia from 2010 to 2018.To see the cause of inflationpersistency, the annual inflation data (year on year) and GrossDomestic Product (GDP) of Surabaya are used.4.1. Results and Analysis the Persistence ofGeneral Inflation and Commodity GroupsAfter knowing the estimation results of the autoregressivemodel (AR), then the AR coefficient on each variable is addedto determine the degree of inflation persistence. The results ofcalculating the degree of persistence of general inflation andcommodity groups are presented in Table 1.TABLE 1PERSISTENCE OF GENERAL INFLATIONAND COMMODITY GROUPSNo.VariableGeneral InflationDegree of Persistence0,98Commodity Group1Foodstuff0,972Prepared Food, Beverages,Cigarettes and Tobacco0,523Housing, Water, Electricity, Gasand Fuel0,974Clothing0,375Health0,986Education, Recreation and Sports0,817Transportation, Communicationand Financial Services0,92Fig. 1. Time Returns to Average Values (months) forGeneral Inflation and CommodityThe results of measuring the degree of inflation persistenceindicate that the general inflation variable has a highpersistence, which is equal to 0.98. This means that the generalinflation behavior in Surabaya tends to be persistent. This isreflected in the length of time needed to absorb 50% of theshock that occurs before returning to its natural level, which is49 months. This finding is in line with various previous studieswhich stated that on average the general inflation behavior invarious provinces in Indonesia tends to be persistent.The next analysis is to measure the level of persistence of thecommodity groups that compile the CPI. Persistence in theCPI-forming commodity group also showed a high average.The Health group had the highest persistence value comparedto 6 other groups, which amounted to 0.98. The time needed toreturn to the average value is 49 months. Meanwhile theFoodstuffs Group which has high volatility because it issusceptible to shock has a persistence value of 0.97 whichmeans it is very persistent. Most of the food supplies in the cityof Surabaya come from outside the region [23], so that itdepends on the production and distribution of the supplier area.The Housing, Water, Electricity, Gas and Fuel group also hasthe same persistence value of 0.97. The high persistence inthese two groups could be because the commodity in the groupis dominated by commodities whose prices are regulated by thegovernment (Administered Price) which causes prices to stiffenso that it is not easy to return to their average values during ashock. Both of these commodities need 32 months to absorb50% of shocks before returning to their natural values.The next commodity groups that also have high persistencevalue are the Transportation, Communication and FinancialServices group as well as the Education, Recreation and Sportsgroup respectively 0.92 and 0.81, where commodity prices inthe two groups are also largely regulated by the government.The time needed to return to the natural value after absorbing50% of shock 11 months and 4 months, respectively.Meanwhile, there are 2 commodity groups showing a lowdegree of persistence, namely the Food, Beverage, Cigarettesand Tobacco group and clothing groups respectively 0.52 and0.37. These two expenditure groups are not included in thevolatile food category or administered prices, meaning that347
Advances in Economics, Business and Management Research, volume 144based on inflation disaggregation the two commodity groupsare not included as non-core inflation. The time needed toreturn to its natural level after absorbing 50% of the shocks wasalso relatively short, i.e. 1 month and half a month respectively.Based on the explanation above, it can be concluded that thecommodity group that has a high degree of inflation persistenceis the commodity group in the administered price categoryfollowed by the volatile food category in which both categoriesare disaggregated by inflation including non-core inflation.This is because commodity prices that are administered pricestend to be rigid and are more difficult to change depending
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