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Wage and price formation in a small open Economy: Evidence from Iceland

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  • Thórarinn G. Pétursson

Abstract

This paper uses an open economy version of a wage-price model with imperfect competition in goods and labour markets to analyse wage and price inflation in Iceland. The model identifies three main sources of wage and price inflation in Iceland: a conflicting claims channel, a real exchange rate channel, and an excess demand channel. The model explains a large proportion of wage and price inflation during the last three decades and is remarkably stable, considering the fundamental changes in the institutional setup in Iceland during this period. There is some evidence of an upward shift in the equilibrium mark-ups in the late 1980s. The results indicate that this was due to a substantial rise in the cost of capital that reflected the move towards market determined interest rates and a shift in policy priorities towards price stability, which cumulated in a path-breaking labour market agreement in early 1990. These changes led to a downward shift in steady state inflation and an upward shift in the natural rate of unemployment.

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  • Thórarinn G. Pétursson, 2002. "Wage and price formation in a small open Economy: Evidence from Iceland," Economics wp16_thorarinn, Department of Economics, Central bank of Iceland.
    • Handle: RePEc:ice:wpaper:wp16_thorarinn
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    Cited by:

    1. Rita Duarte & Carlos Marques, 2013. "The dynamic effects of shocks to wages and prices in the United States and the Euro Area," Empirical Economics, Springer, vol. 44(2), pages 613-638, April.
    2. Ágeir Daníelsson & Lúdvík Elíasson & Magnús F. Gudmundsson & Björn A. Hauksson & Ragnhildur Jónsdóttir & Thorvardur Tjörvi Ólafsson & Thórarinn G. Pétursson, 2006. "QMM A Quarterly Macroeconomic Model of the Icelandic Economy," Economics wp32, Department of Economics, Central bank of Iceland.
    3. Bjarni G. Einarsson & Kristófer Gunnlaugsson & Thorvardur Tjörvi Ólafsson & Thórarinn G. Pétursson, 2015. "The long history of financial boom-bust cycles in Iceland - Part I: Financial crises," Economics wp68, Department of Economics, Central bank of Iceland.
    4. Ásgeir Daníelsson & Lúdvik Elíasson & Magnús F. Gudmundsson & Svava J. Haraldsdóttir & Lilja S. Kro & Thórarinn G. Pétursson & Thorsteinn S. Sveinsson, 2019. "QMM A Quarterly Macroeconomic Model of the Icelandic Economy Version 4.0," Economics wp82, Department of Economics, Central bank of Iceland.
    5. Björn A. Hauksson, 2005. "Aggregate business fixed investment," Economics wp27_bjorn, Department of Economics, Central bank of Iceland.
    6. Howden, David, 2013. "The Rise and Fall of the Icelandic Economy," MPRA Paper 79603, University Library of Munich, Germany.
    7. Gabriel Karagiannides & Christos Liambas, 2019. "Determinacy and Taylor’s Rule with Different Degrees of Trade Openness in a Semi-New Keynesian Model," Applied Economics and Finance, Redfame publishing, vol. 6(6), pages 43-53, November.
    8. Thórarinn G. Pétursson, 2018. "Disinflation and improved anchoring of long-term inflation expectations - The Icelandic experience," Economics wp77, Department of Economics, Central bank of Iceland.
    9. Thorvardur Tjörvi Ólafsson & Ásgerdur Pétursdóttir & Karen Á. Vignisdóttir, 2011. "Price setting in turbulent times," Economics wp54, Department of Economics, Central bank of Iceland.

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