Low inflation in Germany

There exists a long-term equilibrium link between price inflation, CPIt, and the rate of change of labour force, lt=dLF/LFdt, as was shown in this blog for many countries. Germany is a crucial economy to validate this link.  It had a major change in the latest history associated with the reunification. What was the effect of the merge? Here, we model the change in inflation dependence on labour force in 1989. Quantitatively, inflation became less sensitive to the change in labour force by a factor of 4: sensitivity has fallen from -2.2 to - 0.6.  
The estimation method is enhanced relative to our previous studies – the best overall fit is sought by the least squares method as applied to the cumulative curves. In addition to the formal LSQ minimization of the model error we have introduced a varying break year in the model. We allow such a break within 3 years around 1990. By definition, the break year has to provide the lowermost RMS residual. All in all, the best- fit equations for the period before and after 1990 are as follows:
CPIt = -2.2lt-6  + 0.046; t<1990
CPIt = -0.6lt-6 + 0.018; t>1990           (1)
For both periods, the lead of lt is six years. This defines the rate of inflation six years ahead of the current change in labour force. Figure 1 presents the observed and predicted CPI curves, all variables were obtained from the OECD database in 2011. All in all, the predictive power of the model is good and timely fits major peaks and troughs. Because the big lag between the change in labour force and inflation one can foresee the change in prices many years ahead. In Germany, one should not expect high price inflation since the level of labour force has not been growing fast.
The coefficient in (1) obtained for the period after 1990 is not well constrained because the change in inflation is small and statistical estimates are not reliable. The future evolution of the overall CPI in Germany will help to resolve the model better. The previous model published in this blog, was obtained for the whole period and did not include the reunification. Corresponding coefficients were -1.71 and 0.041, which are close to those for the period before 1990.

Figure 1. The rate of CPI inflation in Germany, predicted and measured. The lower panel shows the cumulative curves.

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