Inflation Adjustment in the Open Economy: An I(2) Analysis of UK Prices

We analyse a cointegrated VAR comprising UK data on consumer prices, unit labour costs, import prices and real consumption growth. The nominal variables, treated as I(2) here, form a linearly homogeneous relation, suggesting a transformation of the system to one comprising inflation and relative prices. This is then estimated in I(1) space. An impulse response analysis using the results suggests that higher real import prices reduce real wages, such that the impact of an external shock on domestic inflation is moderated. This explains why the depreciation of sterling in 1992 left inflation unchanged. In contrast, high real import prices in 1974 increased inflation because wage accommodation effects were absent.