Inflation in Western Europe

This chapter will critically discuss the statistical modelling of inflation, defined as the rate of change in a deflator for gross domestic product or gross national product. Statistical work on inflation is not only important for forecasting future inflation, but also for the design, implementation and evaluation of monetary policy. In a closed economy, or an open economy on floating exchange rates, the rate of growth of the money supply is correlated with the rate of inflation, but usually with a long and variable lag. Hence, in a forecasting context, it is likely that regressions of inflation on current or immediate past rates of change in prices, wages and other cost factors together with measures of demand in the goods or labour markets will produce more explanatory power. This explains why professional forecasters tend to emphasize cost factors and the state of ‘excess demand’ rather than monetary developments. At the same time, academic researchers criticize such work for being ad hoc and not based on optimizing behaviour, for data-mining, especially as far as lags are concerned, and for causing confusion between changes in relative prices and changes in the absolute price level.