Explaining Irish Inflation during the Financial Crisis

The recent financial crisis resulted in a steep contraction in the domestic economy together with a sharp decline in inflation. The Phillips curve model of inflation argues that inflation should be negatively related to economic performance and this would seem to be a potential explanatory factor in the behaviour of Irish inflation during the financial crisis. However, Ireland is a very open economy and the Phillips curve has been criticised as an inappropriate model of inflation for Ireland on the basis that inflation is primarily imported from abroad with little role for domestic factors. We formally assess what role domestic economic activity has on inflation in Ireland. We find that while external factors are important in terms of explaining Irish inflation, there are episodes when the domestic economy has an important influence on inflation. In addition, our preferred Phillips curve model predicts actual Irish inflation during the financial crisis quite accurately.