Modelling traded, non-traded and aggregate inflation in a small open economy: The case of Ireland

This paper addresses the unresolved issues surrounding the determination of Irish inflation. The study tests the validity of (i) a pure wage mark-up m odel, (ii) a pure small open economy model and (iii) a hybrid model which f uses elements of(i) and (ii) over the period 1979Q1-1995Q3. Multivariate co integration techniques are employed to clearly distinguish the long-run and short-run information in the data. The results highlight the relevance of the distinction between traded and non-traded prices. For traded prices, fu ll purchasing power parity (PPP) was found to be consistent with the data. In the case of non-traded prices, the data reject strict long-run PPP. Aggr egate price results occupy an intermediate position. Finally, we demonstrat e that strong hi-directional feedback exists between prices and wages.