Domestic and Foreign Effects on Prices in an Open Economy: The Case of Denmark

Domestic price determination in Denmark is investigated using
three kinds of macro-economic explanations: (1) internal labor mar­
ket theories describing the relation between price and wage inflation,
(2) pure monetarist theories describing the effect of excess money
on the inflation rate, and (3) external theories describing the foreign
transmission effects on a small open economy. The empirical analysis
makes use of the multivariate cointegration model, which is based on
the joint analysis of long- and short-run behavior. The deviations
from derived underlying steady states in each sector were found to
be the main determinants of the inflation rate. Among these, the
domestic effects were small compared to the foreign effects. The em­
pirical results strongly favored a backward-looking behavioral model
in terms of structurally stable parameters as opposed to a forward-
looking expectations model. The results stand up as quite strong
evidence against the Lucas critiqueDomestic price determination in Denmark is investigated using
three kinds of macro-economic explanations: (1) internal labor mar­
ket theories describing the relation between price and wage inflation,
(2) pure monetarist theories describing the effect of excess money
on the inflation rate, and (3) external theories describing the foreign
transmission effects on a small open economy. The empirical analysis
makes use of the multivariate cointegration model, which is based on
the joint analysis of long- and short-run behavior. The deviations
from derived underlying steady states in each sector were found to
be the main determinants of the inflation rate. Among these, the
domestic effects were small compared to the foreign effects. The em­
pirical results strongly favored a backward-looking behavioral model
in terms of structurally stable parameters as opposed to a forward-
looking expectations model. The results stand up as quite strong
evidence against the Lucas critique