Transcript Price Setting and Monetary Policy in South Africa

Price Setting and Monetary
Policy in South Africa
PhD Research Proposal by Kenneth Creamer
Supervisor Dr Greg Farrell
School of Economic and Business Sciences,
University of Witwatersrand,
31 October 2006
Overview of Presentation
1.
2.
3.
4.
5.
6.
Abstract and Outline of Research
Background and Overview
Literature Review
Details of survey of price setting conduct
Details of micro-data analysis of CPI data
Modeling implications of pricing for
monetary policy
7. Conclusion
Abstract
This research proposal, firstly, seeks to test the hypothesis that there are significant price
rigidities in the South African economy, and, secondly, seeks formally to model how the
prevalence of such price rigidities would impact on the optimal conduct of monetary policy.
To test for price rigidities, use will be made both of a survey of the pricing conduct of South
African firms and of a micro-data analysis of South Africa’s official consumer price dataset. In
testing for price rigidities, Blinder et al’s (1998) finding for the US economy that 78 percent of the
GDP is priced quarterly or less frequently, and the finding of the European Central Bank’s
Inflation Persistence Network (Altissimo et al 2006) that the average duration of consumer prices
is 4 to 5 quarters, will be treated as benchmarks in assessing the comparative significance of the
degree of price rigidity in the South African economy.
Furthermore, a number of important descriptive features of price setting conduct in the South
Africa economy will be revealed through the survey and the data study, including inter alia the
degree of upward and downward symmetry in price setting, inter-sectoral comparisons of the
frequency, degree and seasonality of price adjustments, and the rating of the applicability of
various microeconomic theories of price setting conduct.
To model the implications of the findings on price rigidities for the optimal conduct of monetary
policy, a framework including a New Keynesian Phillips curve will be developed for South Africa.
This will enable a micro-founded macroeconomic analysis of the co-movement of real and
nominal variables, including a study of the optimal conduct of monetary policy in the presence of
cost push shocks, and will indicate the implication of interest rate setting for output and inflation
and the nominal and real policy rates.
JEL Classifications: E31, E52
Outline of Proposal
1. Introduction
– a. Overview
– b. Macroeconomic context
– c. Literature Review
2. Survey of the price setting conduct of South African firms
– a. Overview
– b. Sample selection
– c. Substance of the Survey
– d. Survey Findings
3. A micro-data analysis of price setting in the South African economy
– a. Overview
– b. Analysis of frequency of price changes
– c. Analysis of size of price changes
4. Modeling the implications of pricing conduct for monetary policy in South Africa
– a. Overview
– b. Modeling the implications of pricing behaviour
– c. Conclusion
5. Bibliography
2. Background and Overview
• In the disciplines of macroeconomics and monetary
economics a significant emphasis has begun to be placed
on the micro-founding of macroeconomic models.
• In this context a number of important recent studies have
been conducted aimed at gaining a better understanding of
price setting behaviour in a wide range of economies
• These studies have used two basic methodologies in order
to better understand price setting behaviour:
– Surveys of individuals responsible for price setting – aimed at
assessing the frequency, direction and size of price changes for the
economy as a whole and across various economic sectors, but also
in order to gain insight into the factors that motivate and shape price
setting decisions
– Micro data analysis of CPI and PPI data – aimed at quantitatively
ascertaining the frequency, direction and size of price changes for
the economy as a whole and across various economic sectors
Why study price setting behaviour?
• The research will throw up a rich new data set which
will provide a deepened understanding of price
setting behaviour in the South African economy,
including findings, such as:
• How frequently are prices changed in South Africa
• Is pricing asymmetrical or are prices as likely to be decreased as
increased?
• Which theories of price setting behaviour best explain price
stickiness in South Africa?
• The findings of the study will have implications for
the conduct of economic policy:
• A model will be develop to show that in situations of relatively high price stickiness,
monetary policy should be less aggressive in responding to cost shocks, such
as, an oil price increase or a sharp currency depreciation
3. Literature Review
The research would begin to fill a significant gap in South Africa’s economic literature as studies on
price setting, inflation, monetary economics and monetary policy in South Africa have generally
pursued a different set of questions from those under discussion in this research proposal.
Aron and Muellbauer (2005) - reviewed monetary policy in South Africa over the past decade,
suggesting that wage setters in South Africa are backward looking as they indexing wages to past
inflation plus a “safety margin”, and that a ‘cost channel’ effect exists whereby higher interest rates
lead to a higher cost of capital and wage pressures, which leads to price setting firms increasing
prices
Fedderke and Schaling (2005) - in their modeling of inflation in South Africa found evidence of
mark-up pricing
Nell (2000a) - shows that inflation is largely due to higher imported prices and wage rates (cost push
inflation) in the period from 1984 to 1998, as compared to demand pull factors in the 1973-1983
period
Roberts and Malikane (2005) - critique the narrow focus of inflation targeting, which is premised
on the prevalence of demand pull causes of inflation, when in fact inflationary pressures may be due
to cost push factors and highlight the negative welfare effects of high inflation on goods purchased by
low income households such as health care, education and food
Bhorat and Oosthuizen (2006) - studied the differential impact of inflation on rich and poor South
African households, showing the effects of distinctive ‘democratic’ and ‘plutocratic’ weightings of
the Consumer Price Index.
Bhundia (2002) - shows that with regard to the impact of exchange rate shocks on inflation in South
Africa, that inflation is more responsive to nominal shocks, when the currency depreciation was
associated with loosening of monetary policy, than to real shocks when the currency appreciated in
response to tighter than expected fiscal policy and a slow down in growth in the global economy
Comparable International Studies
• North America:
– Blinder et al, “Asking about prices: A new approach to understanding
price stickiness”, 1998
– Amirault et al. “Survey of price setting behaviour of Canadian
Companies”, 2006
• European Union:
– Since the year 2000 a number of recent survey and micro data
studies have been conducted under the auspices of the European
Central Bank’s Inflation Persistence Network, including for Spain,
France, Portugal, Germany, Austria, Belgium, Holland and Italy,
including Loupias et al, 2004 and Alvarez and Hernando 2005,
Baudry et al, 2004, Dias et al, 2005
• Other:
– Hall et al, “How do UK companies set prices?”, Bank of England
Quarterly Bulletin, 1996
– Baharad and Eden, “Price Rigidity and Price Dispersion: Evidence
from Micro-data”, Israel, 2003
– Kovanen, “Why do prices in Sierra Leone Change so often? A case
study using micro-level price data?”, IMF Working Paper, 2006
4. Details of Survey of Price Setting Conduct
Overview
• It is envisaged that the survey would include face-to-face interviews with
100 business decision makers drawn from a representative sample of the
targeted component of the GDP. There will be a pilot survey of 10
interviews.
• The objective of the survey would be better to understand price setting
behaviour in South Africa, both:
– of how frequently prices are changed and how quickly prices respond
to cost shocks and demand shocks, and
– an assessment of the validity of various economic theories of price
setting behaviour from the angle of price setters themselves.
• Positive aspect of interview method - assist in assessing otherwise nonobservable issues such as the existence of implied contracts and the impact
of such implied contracts on pricing
• Limitations of the interview methodology - results can be sensitive to the
wording of questions, as in this case where theories of price setting are to
be de-jargonised and written in plain language.
Survey Sample Selection
• The targeted survey sample will be the private, for-profit, un-(price)regulated, nonfarm component of the GDP, which in the US
amounted to about 71% of total GDP and in South Africa would
amount to about 67% of the GDP broken down as follows:
– Manufacturing - 28%
– Construction - 4%
– Wholesale and Retail trade, catering and accommodation - 22%
– Transport Storage and Communication - 15%
– Finance Insurance and Real Estate - 31%
• Following Blinder et al (1998) the exclusions are explained as follows:
– focus is on the private sector as theories of price setting are used to
explain behaviour of profit maximizing firms,
– the price-regulated sector is excluded as in this sector price rigidity is
either trivial to explain (as flexibility is illegal) or requires a complex
theory of government regulatory behaviour, and
– farms excluded as farm prices are not perceived to be sticky.
Sect ors targeted f or surv ey - 2005 Major div isions of SI C (67% of GDP)
Financial I nt ermediat ion,
Insurance, Real Estate and
Business Serv ices
31%
Manuf acturing
28%
Manuf acturing
Construct ion (Cont ract ors)
Construct ion (Cont ract ors)
4%
Transport, Storage and
Communication
15%
Wholesale and retail trade,
cat ering and
accommodation
22%
Wholesale and retail trade, catering and
accommodation
Transport, Storage and Communication
Financial I nt ermediat ion, I nsurance, Real
Est ate and Business Serv ices
Substance of Survey
- Firstly, price setters would be asked a number of
descriptive questions to ascertain their pricing
practices, including the frequency of price reviews
and how responsive price setters are to changes in
costs and changes in demand.
- Secondly, price-setters would be asked to score, from
1 to 4, the importance of a limited number of theories
of price setting behaviour in explaining their firms
price setting, with a score of:
- 1 the theory is rated “totally unimportant”,
- 2 the theory rated “of minor importance”,
- 3 the theory rated “moderately important”, and
- 4 the theory rated “very important”.
Theories to be tested
Some of the theories to be tested will be drawn from those used in Blinder et al’s 1998 study
and other’s will be selected due their a priori relevance to South Africa’s economic conditions.
From Blinder’s study, the top rated theories of pricing behaviour were:
– coordination failure (where firms hold back on price changes, waiting form other firms
to go first),
– cost-based pricing (where price rises are delayed until costs rise),
– nonprice competition (where firms vary nonprice elements such as delivery lags, service
or quality) and
– implicit contracts (where firms tacitly agree to stabilize prices, perhaps out of “fairness”
to customers).
Moderately rated theories of price setting were:
- nominal contracts (where prices are fixed by contracts),
- costly price adjustment (where firms incur costs of changing prices),
- procyclical elasticity (where demand curves become less elastic as they shift), and
- pricing points (where certain prices - like R99,99 - have special psychological
significance).
Poorly rated pricing setting theories were:
- constant marginal costs (where marginal cost is flat and markups are constant),
- inventories (where firms vary inventory stocks instead of prices),
- hierarchy (where hierarchical delays slow down decisions) and
- judging quality by price (where firms fear customers will mistake price cuts for
reductions in quality).
South African specifics
Given South Africa’s economic conditions, other approaches to price
setting to be considered for incorporation into the survey would include the
following:
- whether pricing decisions are aligned to the stated inflation target
- whether pricing decisions take into account future inflation
- whether price adjustments are more likely when inflation is high and that
there is likely to be no adjustment when inflation is low
- whether changes in interest rates impact on price setting conduct
- the manner in which wage setting impacts on price setting conduct
- the extent of backward lookingness or indexation prevalent in price
setting
- whether prices are raised in order to reach revenue targets in the context
of decreased demand,
- on the impact of exchange rate volatility on price setting conduct, and
- possible questions on the impact of import parity pricing and the impact
of trade liberalisation.
Survey Results
• The survey will reveal two sets of findings: descriptive findings and
theory-evaluation findings.
• Descriptive findings for South Africa will include an estimation of how
frequently prices are adjusted in the South African economy, and an
estimation of how long are the lags in price adjustment following a cost or
demand shock.
• Blinder et al’s 1998 descriptive findings for the frequency of price changes
the US economy is that there is significant price stickiness as about 78% of
the relevant sample of the GDP is repriced quarterly or less often, as per
Table 2 on the next slide.
• Also how how long it takes for prices to adjust after a demand or cost
shock, as per Table 3
• The survey will also include an open ended question about why prices are
not changed more frequently, which leads to difficult characterization
problems, but has the advantage that “it gives respondents a chance to
choose their favourite explanation for price stickiness before their minds
are contaminated by hearing any other suggestions”.
Table 2
Number of pri ce ch an ge sin a typi cal ye ar (n =186 re spon se s)
Fre qu e n cy
Perce n tageof Firms
C umulati ve Perce n tage
Less than 1
10,2%
10,2%
1
39,2%
49,4%
1,01 to 2
15,6%
65,0%
2,01 to 4
12,9%
77,9%
4,01 to 12
7,5%
85,4%
12,01 to 52
4,3%
89,7%
52,01 to 365
8,6%
98,6%
More than 365
1,6%
100,0%
Median = 1,4
Table 3
Lags inPri ce Adju stme n ts, in Mon th s
Type of S h ock
Me an lag S tan dard
Number
of Number of ŅIt
De vi ati on
Re spon se s
n e ver
h appe n sÓ
In cre asei n Deman d 2,9
3,2
128
52
In cre asei n Cost
2,8
3,0
163
23
De cre asei n Deman d 2,9
3,7
132
52
De cre asei n C ost
3,3
3.9
101
73
Survey results
• Theory-evaluation findings will include an evaluation of the applicability
of competing theories of price setting behaviour in the South African
context. Such findings will be presented on an aggregate basis as well as
on a by industry basis.
• Analysis of survey data would include an ordered probit analysis of the
survey results to assess how the observable attributes of various firms assist
in explaining the importance which price-setters attach to each theory of
price stickiness.
• For example, Blinder et al (1998), found that firms in the construction and
mining sector are unlikely to regard adjustment costs (or menu costs) as an
important reason for price stickiness, as follows:
The Importance of Menu Costs (Theory B8) = – 1,84 CON – 1,46
RETAIL – 0,57 WHOLESALE + 0,46 FLATMC – 0,35 CYCLICAL +
0,008 CONSUMER – 0,15 WRITTEN – 0,48 LOYAL
• Perhaps because construction firms work to order. In addition firms with
written contracts are less likely to perceive adjustment costs as an
important source of price rigidity.
5. Details of micro-data analysis South Africa’s CPI data
•
An empirical analysis of the large sample unit
level or micro-data set of the Consumer Price
Index (CPI) is proposed, which will allow
findings to be made on the following issues:
–
–
the frequency of price changes (and the related
duration of price setting) in the South African
economy, and
the size and direction of price changes in the South
African economy.
(Broadly the methodology adopted by Alvarez and
Hernando, 2004 is to be followed.)
Frequency of price changes
•
•
•
•
•
•
This study will for the first time produce a set of results for South Africa
comparable to Table 4’s results for Spain (from Alvarez and Hernando, 2004)
This shows findings as to the frequency of price changes (measured in terms of
the average proportion of prices changing each month over the most recent 45
month period for which data is available from Statistics South Africa).
For example, in Table 4, 50% of unprocessed food prices change each month,
with 26% of unprocessed food prices rising each month and 23% of
unprocessed food prices declining each month.
The study will also enable findings as to whether price setting is asymmetrical
or symmetrical upwards and downwards.
A finding will also be made as to whether the frequency of price setting is
homogenous or non-homogenous across product categories.
An analysis of factors influencing the frequency of price setting is also
proposed, including such factors as seasonality, the prevailing rate of inflation,
preference for round prices, changes in excise duties, exchange rate
developments (not included in Alvarez study), and interest rate developments
(not included in Alvarez study, but which could assist in analyzing the cost
channel aspect of South Africa’s transmission mechanism).
Table 4
Monthly frequencyof price changes
Main
Frequency of Frequency of Frequency of
component
price changes price increases price decreases
Unprocessed 0,50
0,26
0,23
food
Processedfood
0,11
0,07
0,18
Non-Energy 0,07
0,05
0,02
industrial
goods
Services
0,06
0,05
0,01
All items
0,15
0,09
0,06
% of price
increases
53.1%
59,0%
74,9%
86,5%
62,2%
Size of Price changes
• Findings for the first time for South Africa will include, both
for the CPI as a whole and the main components of CPI:
– the average percentage change in prices for all items,
– average price increases, and
– the average price decreases (assuming a maximum of one
price change per period). (See comparable results for Spain
in Alvarez et al’s Table 5)
• An analysis of factors influencing the size of price changes is
also proposed, including such factors as seasonality, the
prevailing rate of inflation, preference for round prices,
changes in excise duties, exchange rate developments (not
included in Alvarez study), interest rate developments (not
included in Alvarez study).
Table 5
Size of Price Changes
CPI Component Average
Price Average
Change
Increase
UnprocessedFoods 15,2%
14,9%
Price Average
Decrease
-15,6%
ProcessedFood
7,3%
6,9%
-8,0%
Non-energy
industrial goods
Services
6,5%
6,1%
-8,3%
8,4%
8,2%
-11,2%
All items
8,6%
8,2%
-10,3%
Price
6. Modeling implications of price setting behaviour
for optimal conduct of monetary policy
• An important objective of the research is formally to show the
implications of the finding on price setting behaviour in South
Africa for the optimal conduct of the country’s monetary policy.
• A model such as that developed by Altissimo et al (2006) can be
used to show that in comparing situations of high and low
degrees of price rigidity, monetary policy should be less
aggressive in the face of cost push shocks in order to achieve
optimal output, interest rate and inflation outcomes.
• In this regard, the minimization of a loss function is used to
assess the optimal conduct of monetary policy. For example, the
following loss function penalizes deviations from employment,
inflation and output growth targets: L = a1(U-U*)2 + a2(PP*)2+a3(Y-Y*)2 where a1, a2, a3 >0. Altissimo’s model (2006)
uses a variation of this loss function, as it places a dominant
weight on inflation stabilization (0,85) and smaller weights on
the stabilisation of the output gap (0,075) and the interest rate
changes (0,075).
Modeling policy implications
• The Altissimo et al model is based on a Phillips
Curve, IS curve and Taylor rule, as follows:
• Phillips curve:
t 1
t 1
1 t
• IS Curve:
• Taylor Rule:
    (1   )E  y  
yt  yt 1  (1   )Et yt 1   (rt  Et t 1 )   t
rt  rt 1  (1   )( Et t 1 Et yt 1 )
Where: Π = inflation, y = the output gap, E = expectations operator, u = a cost push shock, ε = a
demand shock, r = the policy rate, κ = the degree of response of inflation to output, σ =
variance of cost push shocks, λ = extent of interest rate smoothing by authorities, and γ =
proportion of backward looking or price-indexing firms
The workings of the model
The model responds to a cost-push shock u (typically
a single standard deviation increase in prices) as
follows:
- an increase in prices (due to u) leads to an
increase in inflation  (Phillips Curve relation)
- the increase in  lead to an increase in the policy
interest rate r (Taylor rule)
- this leads to a restraining of output growth y (IS
curve)
- which ultimately leads to reduced pricing and
containment of inflation (Phillips curve).
The effect of price stickiness and backward
indexing of prices
• The degree of price stickiness affects the response of inflation to
output variations, κ. With stickier prices being associated with
smaller κ values.
• As indicated by the following Diagram, the model has different
outcomes depending on whether the degree of price stickiness in the
economy is low (prices set for two quarters), medium (prices set for
three quarters) or high (prices set for four quarters) (associated with
smaller κ values) . The diagram indicates the impact of the degree
of price stickiness on the response of output, inflation and the
nominal and real policy rates.
• The model also provides for analysis of the optimal conduct of
monetary policy in the context of varying degrees of intrinsic
inflation persistence (indicated by γ in the model).
Intrinsic
inflation persistence increases with the increase in the degree of
backward-looking indexation with reference to previous inflation in
price setting (associated with rising γ in the model).
Why do price rigidities
matter?
• There are two key reasons why a higher degree of price
stickiness implies a less aggressive monetary policy
reaction.
– Firstly, due to price stickiness a given increase in the
nominal interest rate will have a larger effect on the real
rate and on output.
– Secondly, with higher price stickiness credible monetary
authorities have a greater incentive to smooth out their
policy response (to avoid the sacrifice ratio without
risking inflation), resulting in smaller initial output gap
response, but one which is prolonged and cumulatively
significant.
7. Conclusion
• Findings concerning price setting behaviour in the
South African economy will be used to calibrate a
model appropriate to South African conditions.
• This will enable a detailed discussion on how price
setting behaviour can be shown to impact upon the
optimal conduct of monetary policy in South Africa,
particularly in the context of cost-push shocks.
• The research will conclude with an integration of the
theoretical and empirical results into a discussion
about the optimal conduct of monetary policy in
South Africa.