Inertial Inflation, Indexation and Price Stickiness: Evidence from Brazil

This paper evaluates the inertial inflation hypothesis for Brazil during the 1970s and the first half of the 1980s. According to this hypothesis, (wage) indexation created a feedback mechanism such that one-time supply shocks were fully transmitted into permanent increases in inflation. First a simple theoretical model is used to show that the hypothesis is based on the assumption of perfect price flexibility. When price stickiness is introduced, indexation does not produce inertial inflation. Then, to investigate the impact of indexation on inflation, the degree of inertia (persistence) is compared between two periods, one with widespread indexation (1969-1985) and an earlier one without indexation (1945-1963). Unit root tests and the variance ratio test are used. The variance ratio test is also applied to inflation in the U.S. for the period (1969-1985) and France for (1983-1993), a period when there was no wage indexation. Finally, vector-autoregressive representations are estimated for the period 1972-1985. They differ from earlier work in that price tickiness is allowed for. The empirical results do not support the inertial inflation hypothesis; inertia does not seem to have been unusually high during the period of indexation, and impulse response analysis indicates that inflation shocks had only short-run effects on the level of inflation.