An application of New Keynesian models to inflation in Croatia

Background: The inflation dynamics of Croatia is studied in the paper, with the review of applicable marginal cost proxies for the hybrid New Keynesian Phillips Curve (NKPC), and estimation of three specifications of the hybrid NKPC for Croatia. Objectives: The goal of this research is to examine the effect of labor’s share of income, the price of energy, and the price of imports and other open economy factors in driving inflation in Croatia from the first quarter of 2000 to the fourth quarter of 2011. Methods/Approach: We use the generalized method of moments (GMM) estimator to empirically estimate three NKPC specifications. The J-stat and Cragg-Donald F-test are used to test for overidentification and for weak instruments, respectively. Results: We find that the marginal cost proxy for the energy-augmented specification is statistically significant and quantitatively the largest, whereas those for the other two are statistically significant, but quantitatively negligible. Conclusions: The results provide an empirical contribution both to the literature on inflation in Croatia and the literature of the NKPC in a small open economy. We can conclude that the price of energy has been the strongest driver of inflation, whereas the open economy factors we tested have had very little influence.