An Approximate Error-Correction Model for the Relation between Prices, Money and Exchange Rate in Costa Rica

The long-term relation between the level of prices, the monetary aggregates(M1 and M2), and the exchange rate (TC) is investigated in this paper for the Costa Rican economy. An error-correction model is proposed to mimic the short-term dynamics. The cointegration technique is used to study the long-term behavior based on the assumption that all the variables involved have the same degree of integration. The first differences of the long-term series provide an equation for the short-term case. On the average, prices are affected, respectively, by 0,67% and 0,13% by a 1% increase in the TC and M1. The coefficients of the short-term model, 0,23 for TC and 0,05 for M1, are smaller than the corresponding long-term ones. The error-correction term shows that the adjustment after a "shock" is relatively slow and equal to 0,11%. In this sense, the error term contains the information not captured by the cointegration regression (long-term). In the short-term, the adjustment towards equilibrium is slow. This implies that the correction in each period is approximately equal to 11% of the divergence, fact consistent with a monthly equation. Based on this estimation, it is concluded that in about nine months the divergence caused by the initial "shock" would be corrected. In addition, the short-term effect of the inflationary inertia is higher than both the TC's and M1's effects. Concerning monetary and exchange policies, it is shown that the significant inflow of capital that began in 1990 did not exert a strong pressure over prices. Possible causes could have been a compensatory movement via external sector, an increase in the level of imports, and stricter monetary control