A P* Approach to Price Adjustment in Developing Countries: A Panel Study

This paper examines the role of disequilibrium conditions in influencing price adjustment processes in developing countries. Measures of real and financial sector disequilibrium are constructed for a sample of 58 developing countries over the period 1973-1998 using structural VAR methodology. Panel data techniques are used to estimate a reduced-form P* model. Overall the results suggest that inflation expectations are relatively forward looking in developing countries. This is consistent with the elevated inflation rates that many of these countries have experienced over long periods of time. The evidence for the role of real or financial sector disequilibrium conditions in the price adjustment process is limited. The output gap is significant for most countries, with the negative sign suggesting that temporary fluctuations in output, and subsequent price adjustment processes, reflect the response of output and prices to temporary supply shocks. The velocity gap does not seem to play an important role, and the external price gap appears only to be significant for the African and Western Hemisphere regions.