The scandinavin model of inflation: A generalization and empirical evidence
In this paper we consider an inflation model for a small open economy. "Smallness" is defined by the assumption that the economy meets an infinitely elastic demand and supply function for its tradable commodities, i.e., the country is assumed to be a price-taker in the world market. This implies that the rate of inflation of a small open economy depends upon the world rate of inflation. On the other hand, we observe a remarkable difference in the rates of inflation among various countries. Some Scandinavian authors like Odd Aukrust [1] and the group of authors Gtista Edgren, Kafl-Olof Faxen and ClasErik Odhner [7] have proposed a simple model which links the rate of inflation of a small open economy with international price developments and which also allows for differences in the rates of inflation among countries. The Scandinavian model of inflation received recently an increasing attention by European economists analysing its theoretical underpinnings and its empirical content [4, 5, I0, 12, 14, 15, 17]. Crucial for the model is the division of the economy into two sectors. The exposed sector (E-sector) produces "tradables," i.e., commodities that compete on the world market, the sheltered sector (S-sector) produces "non-tradables," i.e., commodities which are not traded internationally. The model assumes further fLxed exchange rates and explains the domestic rate of inflation through the world rate of inflation and a structural component which depends on domestic parameters.