Inflation in Ireland: Theory and Evidence

The purpose of this paper is to address some important questions surrounding the determinants of Irish inflation. As a backdrop, the international theoretical literature on inflation is selectively reviewed, with a view towards assessing its relevance to Ireland. Subsequently, the relevant Irish empirical literature is assessed in order to highlight the main outstanding areas of disagreement surrounding the determination of Irish inflation. This is contrasted with the widespread agreement which prevailed prior to our entry into the EMS. Following on from this, an empirical model of aggregate Irish inflation is formulated with a view towards specifically addressing the roles of (i) the exchange rate, (ii) wages and (iii) foreign factors in the determination of Irish inflation. Our overall results, obtained using the Johansen multivariate cointegration technique, highlight the long-run interrelationships between Irish prices, wages and the nominal effective exchange rate. In addition, it is shown that the purchasing power parity model is an acceptable long-run framework within which to consider price determination in Ireland. However, the results also support the view that excessive wage pressure, or domestic inflationary impulses in general, can exert upward pressure on Irish prices as long as the exchange rate is free to move. * The authors would like to thank John Frain, Tom O’Connell and other colleagues in the Central Bank for helpful suggestions on an earlier draft. We would also like to thank participants at a Dublin Economics Workshop seminar for their helpful suggestions. Comments from Professor Dermot McAleese and two anonymous referees were also gratefully received. The views expressed in the paper are not necessarily those held by the Bank and are the personal responsibility of the authors.