Kitov, Ivan and Kitov, Oleg and Dolinskaya, Svetlana (2007): Relationship between inflation, unemployment and labor force change rate in France: cointegration test.

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Abstract
A linear and lagged relationship between inflation, unemployment and labor force change rate, π(t)=A0UE(tt0)+A1dLF(tt1)/LF(tt1)+A2 (where A0, A1, and A2 are empirical countryspecific coefficients), was found for developed economies. The relationship obtained for France is characterized by A0=1, A1=4, A2=0.095, t0=4 years, and t1=4 years. For GDP deflator, it provides a root mean square forecasting error (RMFSE) of 1.0% at a fouryear horizon for the period between 1971 and 2004. The relationship is tested for cointegration. All three variables involved in the relationship are proved to be integrated of order one. Two methods of cointegration testing are used. First is the EngleGranger approach based on the unit root test in the residuals of linear regression, which also includes a number of specification tests. Second method is the Johansen cointegration rank test based on a VAR representation, which is also proved to be an adequate one via a set of appropriate tests. Both approaches demonstrate that the variables are cointegrated and the longrun equilibrium relation revealed in previous study holds together with statistical estimates of goodnessoffit and RMSFE. Relationships between inflation and labor force and between unemployment and labor force are tested separately in appropriate time intervals, where the Banque de France monetary policy introduced in 1995 does not disturb the longterm links. All the individual relationships are cointegrated in corresponding intervals. The VAR and vector error correction (VEC) models are estimated and provide just a marginal improvement in RMSFE at the fouryear horizon both for GDP deflator (down to 0.9%) and CPI (~1.1%) on the results obtained in the regression study. The VECM approach also allows reestimation of the coefficients in the individual and generalized relationship between the variables both for cointegration rank 1 and 2. Comparison of the standard cointegration approach to the integral approach to the estimation of the coefficients in the individual and generalized relationships between the studied variables demonstrates the superiority of the latter. The cumulative inflation curve or inflation index, which is the actually measured evolution of price level, is much better predicted in the framework of the integral approach, which is a powerful tool for revealing true relationships between nonstationary variables and can be potentially used for rejection of spurious regression. The cumulative curves allow avoiding obvious drawbacks of the VECM representation and cointegration tests – increasing signal to noise ratio after differentiation and severe dependence on statistical properties of error terms. The confirmed validity of the linear lagged relationship between inflation, unemployment and labor force change indicates that since 1995 the Banque de France has been wrongly applying the policy fixing the monetary growth to the reference value around 4.5%. As a result of the policy, during the last ten years unemployment in France was twice as large as the one dictated by its longterm equilibrium link to labor force change. This increased unemployment compensates the forced price stability.
Item Type:  MPRA Paper 

Institution:  IDG RAS 
Original Title:  Relationship between inflation, unemployment and labor force change rate in France: cointegration test 
Language:  English 
Keywords:  cointegration; inflation; unemployment; labor force; forecasting; France; VAR; VECM 
Subjects:  C  Mathematical and Quantitative Methods > C3  Multiple or Simultaneous Equation Models ; Multiple Variables > C32  TimeSeries Models ; Dynamic Quantile Regressions ; Dynamic Treatment Effect Models ; Diffusion Processes ; State Space Models E  Macroeconomics and Monetary Economics > E3  Prices, Business Fluctuations, and Cycles > E37  Forecasting and Simulation: Models and Applications E  Macroeconomics and Monetary Economics > E3  Prices, Business Fluctuations, and Cycles > E31  Price Level ; Inflation ; Deflation J  Labor and Demographic Economics > J2  Demand and Supply of Labor > J21  Labor Force and Employment, Size, and Structure E  Macroeconomics and Monetary Economics > E3  Prices, Business Fluctuations, and Cycles > E32  Business Fluctuations ; Cycles 
Item ID:  2736 
Depositing User:  Ivan Kitov 
Date Deposited:  15. Apr 2007 
Last Modified:  29. Apr 2015 22:25 
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URI:  http://mpra.ub.unimuenchen.de/id/eprint/2736 