INFLATION DIFFERENTIAL BEETWEN EURO AREA AND NORTH MACEDONIA

Abstract

The main purpose of this study is to make a comparative analysis of the inflation differences between euro area and North Macedonia and to propose a simple model for inflation calculation for the North Macedonian economy by using an OLS regression of several explanatory variable to estimate the inflation level. Since the common currency was establish by the European countries the monetary policy is conducted by the European Central Bank (ECB) with the primarily goal of price stability i.e. low inflation, by considering the interest of all members of the European Monetary Union (EMU). The focus of the ECB on low inflation pressured the governments of various euro zone countries to develop the appropriate models to measures inflation and respond in time to shocks that may affect them. Historically, since its creation, the ECB has made a good effort in containing the inflation within the boundaries of 2% annually. On the other note it cannot be stated that this is the case for the North Macedonian National Bank, where inflation is subject to considerable variations. First a comparative method is used to show the evolution of inflation differentials between euro area and North Macedonia for the period 2000-2024. Inflation, is calculated as annual percentage of consumers price. From 2000 inflation differentials where increasing until 2009, reaching a minimum in 2004 and a peak in the year 2008. Afterwards the inflation dispersion decreased until 2021, before the COVID pandemic, there was a temporary upsurge to reach its peak in 2022, passing the 2008 level, before decreasing again in 2024. The other approach taken in this paper is to present a model for inflation calculation based on the formulation by Honohan et al. (2003) and Angeloni and Ehrmann (2004). The economy of North Macedonia is modeled only as an aggregate supply where inflation is depended on past and expected inflation, domestic output gap, and the real effective exchange rate weighted by the appropriate trade share of the North Macedonian economy. From all the explanatory variables of the model only the effective exchange rate is statistically significant at the 5% level, meaning that the association between Inflation and Reer is significant. Apart from the explanatory variables, the constant -97.36 is statistically significant at 10% level and represents the expected average level of inflation in the case where each independent variable is null. The study, culminated by creating a least square model to detect the relationships between various explanatory variables and inflation. The same model identifies that only the effective exchange rate is significant at 5% level and all the other variables although they are important in explaining inflation they are not statistically significant. From this study, it can be also concluded that it does not include all the macroeconomic factors that influence inflation. The determinants used in the model have an R squared of only 0.386 which means that they explain only 38.6% of Inflation.