What Drives Prices in Egypt?

An Analysis in Light of International Experience

Hanaa Kheir-El-Din

• Publisher: The American University in Cairo Press
• Year: 2009
• ISBN:
  9781617973857
• Topic: Économie
• Subtopic: Politique monétaire

Since 2004, economic reforms in Egypt have led to robust expansion, a healthy external position, and enhanced investor confidence. But despite these positive macroeconomic developments, inflation has been steadily rising. Does fiscal policy threaten price stability? Does wage growth in the Egyptian economy lead price inflation, or is it the reverse? In this volume, these and other questions are examined by contributors who participated in a conference held in Cairo in late 2007.Here is a coherent and comprehensive analysis of the factors driving prices in Egypt, in an attempt to find a satisfactory balance between prices and economic growth. While Egypt is the focus of the analysis, the papers draw upon the relevant literature, and international experience, the findings can be applied to other middle-income economies. This timely study helps to explain the complex issues facing economists and policymakers, with proposals for reform.Contributors: Hala Abou-Ali, Hala Fares, Omneia A. Helmy, Alaa Ibrahim, Hanaa Kheir-El-Din, Rania Al-Mashat, Diaa Noureldin, Klaus Schmidt-Hebbel, and Sherine Al-Shawarby.

CHAPTER 1

Great Moderation and Inflation
Targeting in the World¹

Klaus Schmidt-Hebbel

The last two decades have seen a major improvement in the world’s macroeconomic performance. Inflation levels and volatilities have declined and output growth rates are more stable in all major world regions. The inflation decline and the overall reduction in second moments of both inflation and output growth have been dubbed the Great Moderation after the more unstable decades of the 1970s and 1980s.

Possible explanations for the Great Moderation can be grouped into four categories. First, improved institutional quality and stronger political and policy consensus in most countries could reflect a shift in preferences toward more macroeconomic stability. Better choices and improved implementation of macroeconomic regimes and policies are likely to be a second driving force. Third, structural and technological changes in the operation of economies—including market creation, financial development, and information technology improvement—could contribute to stabilization. Finally, there is good luck: stability could be a result of smaller and less frequent supply shocks observed during the last two decades.

Assessing the relative contribution of the ultimate causes of the Great Moderation is important both for the assessment of policies and the likelihood of its future sustainability. The world supply shock reflected by high commodity prices that has been unfolding since 2006 and the turmoil observed in world financial markets since mid-2007 will provide a test case for checking if global macroeconomic stability—and its underlying policies—is robust in a world environment of adverse luck.

This chapter focuses only on one policy candidate that may have contributed to worldwide stabilization: the potential improvement in monetary policy derived from the adoption of inflation targeting (IT) in many industrial and emerging-market economies (EMEs). Therefore, this chapter assesses the success of IT by reporting panel-data evidence for inflation-targeting countries in comparison to their own past performance and relative to a control group of high-achieving industrial countries that do not target inflation. It is shown that the adoption of IT improves macroeconomic performance compared to the pre-adoption stage, with special quantitative importance in EMEs. This improvement in macroeconomic performance reflects the contribution of IT to worldwide Great Moderation. Despite the latter’s favorable results for IT, the evidence does not generally show that countries under IT have attained better monetary policy performance relative to the control group of highly successful non-inflation targeting industrial countries.

The Great Moderation

Economic growth has been nothing but vigorous in the past decade. International financial crises in the late 1990s, followed by the dotcom bubble burst, certainly had a negative effect on world economic growth, but subsequent recovery was particularly fast and vigorous when compared to previous crises and cyclical downturns. World economic growth has not only been strong but has also been remarkably stable. Output growth volatility has declined in all major regions of the world, as depicted in Figure 1.1, which shows GDP growth volatility, measured by its standard deviation for ten-year rolling windows. After a somewhat long period of higher world growth volatility (from 1972 to 1982), it displays a systematic downward trend. Only Asia and, to a lesser extent, Latin America exhibited higher growth volatility during the Asian Crisis, but reverted toward low trend world growth volatility in the subsequent years.

During the decade spanning 1996 to 2006, world GDP growth volatility reached the low value of the 1960s (0.9 percent), after a spike of high volatility (2 percent) in the decade from 1975 to 1985. As reported in the IMF’s World Economic Outlook (2007), even though world volatility is the same as in the 1960s, individual country volatilities are rather lower. The standard deviation of median country growth declined from 3.8 percent in 1960 to 2.7 percent in 2006. Thus the apparently similar world standard deviations of the 1960s and the last decade (1996–2006) hide the effect of larger covariances between countries. Forty years ago, individual country growth volatilities were higher, but countries’ business cycles were less correlated (lower covariances), whereas in the most recent decade individual country GDP growth volatilities have dropped further while cross-country covariances have increased and are generally positive. Globalization—larger financial and trade integration—is behind countries’ increased cyclical co-movements.

Figure 1.1. GDP Growth Volatility in Major Regions, 1960–2006 Standard Deviation of 10-Year Rolling Windows (%)

Source: Author’s calculation based on World Bank, World Development Indicators (2007).

Similar results are observed for inflation convergence. Inflation levels have declined in all world regions. Chronic inflation has been almost wiped out, while world and regional inflation levels have become very stable around low average levels. Figure 1.2 depicts CPI headline inflation averages for different regions and the world at large. Except for Central and Eastern Europe, where many countries underwent intense but temporary macroeconomic instability in their transition toward market economies in the early 1990s, the last decade has been pre-dominantly characterized by one-digit inflation rates converging to levels around or below 5 percent per year.² The convergence toward low inflation is also associated with a major reduction of inflation volatility in all regions.

While reduced variability of output growth and inflation is a worldwide phenomenon, the start of the Great Moderation differs among countries and regions. Summers (2005) estimates the probability of experiencing high and low volatility of GDP growth for the G7 and Australia. The likelihood associated with high volatility is estimated to be very high in the 1970s–1980s, at values close to one, and then declines to values close to zero at quite different dates. Indeed, the timing of this abrupt change differs markedly across these eight industrial countries: Germany experiences it around 1971, Japan and France in the mid-1970s, Italy and the UK in the early 1980s, Australia and the United States in 1984, and Canada in 1988.

The reduction in output and inflation volatility started much earlier among industrial countries than in developing-country regions, as Figures 1.1 and 1.2 make clear. In fact, inflation reached hyper-inflation levels in many Latin American and transition economies in the 1980s and early 1990s. The Great Moderation is a relatively new phenomenon in most emerging-economy, transition, and developing countries, in contrast to two decades or more of macroeconomic stability in industrial or high-income countries.

Figure 1.2. CPI Headline Inflation in Selected Groups of Countries, 1980–2007 (%) GDP Weighted Average

Source: Author’s calculation based on International Monetary Fund, World Economic Outlook (2007).

The differences in the timing of changes in volatility suggest that there is no unique common external force behind the Great Moderation—it is neither common world shocks nor common structural changes like the integration of China and India into the world economy. Hence, domestic changes, which may be of the same nature but are adopted at different dates by individual countries, are more likely to lead to macroeconomic stability. Such reforms are most likely related to changes in macroeconomic regimes and policies.

What Drives the Great Moderation?

Price stability is widely recognized in the literature as a welfare-enhancing condition that fosters economic growth, makes business planning easier, facilitates financial deepening, reduces resources devoted to uncertainty hedging, and supports more equal income distribution. Output growth volatility is positively correlated with income and consumption volatility—hence output stability also leads to larger welfare. The concern for welfare, policy sustainability, and the assessment of future macroeconomic stability in the world leads to a search for the causes behind the Great Moderation. The literature has identified four categories of driving forces.

The first set of explanations is related to stronger political and policy consensus and improved institutions that support macroeconomic stability. If consensus among the main political parties is attained, sustainable institutions that provide a general framework for macroeconomic stability are more likely to be adopted, maintained, and refined over time. Among the institutional changes, following which most economies exhibited major improvements over the past two decades, are improved property rights, better governance and accountability of governments and public sector institutions, and major gains in central bank independence.

Improvements in macroeconomic regimes and policies comprise the second set of steps that lead to macro stability in the world. Most economists would agree that macroeconomic policy conduct has evolved greatly since the 1960s and 1970s, when policy conduct was particularly poor. Bernanke (2004) highlights the fact that during the 1970s, monetary policy decisions were taken under the influence of misconceived understandings and models of monetary policy and the functioning of the economy. At that time central bankers were excessively confident about the ability of monetary policy as a counter-cyclical tool and, much...

Table of contents

• Cover
• Halftitle page
• Title page
• Copyright
• About
• Contents
• Contributors
• Acknowledgments
• Introduction
• 1. Great Moderation and Inflation Targeting in the World
• 2. Measuring Inflation in Egypt: Assessment of the CPI Accuracy
• 3. Inflation and Growth in Egypt: Is There a Threshold Effect?
• 4. Monetary Policy in Egypt: A Retrospective and Preparedness for Inflation Targeting
• 5. The Impact of Budget Deficit on Inflation in Egypt
• 6. Wage–Price Causality in the Egyptian Economy (1990–2005)
• 7. Relative Price Adjustment and Inflation Dynamics: The Case of Egypt
• Index