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The P-Star Model in Australia and New Zealand

Author

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  • Ramya Hewarathna

    (School of Economics, La Trobe University)

Abstract

This paper studies the usefulness of the P-star model in the analysis of the behaviour of prices in Australia and New Zealand. The P-star model is based on the quantity theory of money and the belief that the price level tends to move towards the equilibrium price level. The main contribution of this model is the use of the price gap - the difference between current price and the equilibrium price (P-star) - to forecast inflation. Hence, if the equilibrium price is greater than the current price, there is a tendency for the price level to rise. The equilibrium price in this approach is determined by potential output, the equilibrium velocity of money and the amount of money in the economy. In this study, potential output and equilibrium velocity, which are necessary variables in the construction of the equilibrium price level (P-star), are derived using the Hodrick and Prescott filter. The information contained in the price gap about Australian and New Zealand inflation is examined using an error correction model. In contrast to findings for the USA, the evidence does not strongly support the P-star model for Australian prices. However, results support the P-star model for the New Zealand case. Furthermore, according to the proponents of the P- star model the lagged value of the price gap must be significant in the model of inflation. But results of this study suggest that the contemporary value of the price gap is significant and it is difficult to provide a theoretical interpretation for this finding.

Suggested Citation

  • Ramya Hewarathna, 2000. "The P-Star Model in Australia and New Zealand," Working Papers 2000.07, School of Economics, La Trobe University.
    • Handle: RePEc:trb:wpaper:2000.07
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    References listed on IDEAS

    as
    1. Hallman, Jeffrey J & Porter, Richard D & Small, David H, 1991. "Is the Price Level Tied to the M2 Monetary Aggregate in the Long Run?," American Economic Review, American Economic Association, vol. 81(4), pages 841-858, September.
    2. Thomas M. Humphrey, 1993. "Money, Banking and Inflation," Books, Edward Elgar Publishing, number 236.
    3. Mr. Richard D Haas & Mr. Robert J. Corker, 1991. "Price Pressure Gaps: An Application of P* Using Korean Data," IMF Working Papers 1991/026, International Monetary Fund.
    4. Jeffrey J. Hallman & Richard D. Porter & David H. Small, 1989. "M2 per unit of potential GNP as an anchor for the price level," Staff Studies 157, Board of Governors of the Federal Reserve System (U.S.).
    Full references (including those not matched with items on IDEAS)

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    Keywords

    BEHAVIOUR ; MODELS ; PRICES;
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