The Australian National University

Asia Pacific School of Economics and

Government

International and Development

Economics

Quantitative International
Economics

Inflation Dynamics in Transition

Economy of Lao PDR.

Submitted by: Fongchinda Sengsourivong

U4082083

Submitted to: Tom Kompas and

Ligang Song

Date submitted: 8 June 2005

Table of Contents

TABLE OF CONTENTS ................................................................................................................................. 2

ACKNOWLEDGEMENTS ............................................................................................................................. 3
ABSTRACT ...................................................................................................................................................... 4

INTRODUCTION ............................................................................................................................................ 5

LITERATURE REVIEW ................................................................................................................................ 6

MODEL SPECIFICATION ............................................................................................................................ 9

DATA AND ESTIMATION METHODOLOGY ........................................................................................ 10

DATA DESCRIPTION ...................................................................................................................................... 10
ESTIMATION METHODOLOGY ....................................................................................................................... 10
Unit roots test.......................................................................................................................................... 10
Johansen co-integration test ................................................................................................................... 11
Engle and Granger: Error Correction Models ....................................................................................... 12
Hausman endogeneity test ...................................................................................................................... 13

EMPIRICAL RESULTS................................................................................................................................ 13
UNIT ROOTS TEST RESULTS ........................................................................................................................... 13
JOHANSEN CO-INTEGRATION TEST RESULTS ................................................................................................. 14
THE ERROR CORRECTION MODEL RESULTS ................................................................................................... 14
LONG-RUN PRICE EQUILIBRIUM .................................................................................................................... 16
HAUSMAN ENDOGENEITY TEST RESULTS..................................................................................................... 17

DISCUSSION AND ANALYSIS OF RESULTS ......................................................................................... 18

CONCLUSION............................................................................................................................................... 21

REFERENCES ............................................................................................................................................... 23

APPENDIX A ................................................................................................................................................. 25
APPENDIX B.................................................................................................................................................. 30

2
 Acknowledgements

I wish to express my gratitude to my research essay supervisor Dr. Tom Kompas for his
insightful comments and support. I also would like to thank to our Academic and Research
Skills Advisor, Anne Patching, for her English editing and structure of the essay.

3
 Abstract

This paper investigates the relationship between inflation and macroeconomic variables

using a sample of Laos in the period 1992-2004. Based on one-step error correction model

of Engle-Granger approach, foreign price and exchange rate show the strong correlation

with inflation process in Laos. This can be explained by a high degree of trade dependency

in Lao economy. However, monetary base has the low impact on the price pressure partly

because of monetary policy actions. Dollarization has influenced price instability in the

short-run influences rather than in the long-run. In addition, there is evidence of inflation

inertia in the process of inflation in Laos. Foreign interest rates positively relates to long-

run inflation pressure in Laos through the transmission of traded good prices and

dollarization channels. This paper also takes the endogeneity issue of explanatory variables

into account by using the Hausman test approach. The endogeneity test shows that the

model of single price equation may experience the endogeneity problem because monetary

base shows evidence of interrelationship with price process.

4
Introduction
Inflation is a global problem because almost all countries have suffered from one time or
another. Generally, inflation creates lower purchasing power and generates lower incomes,
especially in developing countries. Based on the recent history of high inflation in transition
economies, determinants of price instability in those emerging countries have been
extensively studied in the academic literature. Four main sources have focused on
examining the inflation process. First, fiscal dominance has associated to money growth
(Walsh 2003:145). Loungani and Swagel (2001); Fisher et al. (2002); and Lissovolik
(2003), found that fiscal imbalance related to money growth is highly possible to push the
price up. Second, balance of payment views related to a high level of openness - goods and
finance markets – assert that exchange rate pass-through has a high potential affecting
inflation instability. Montiel (1989); Bailliu et al. (2003); Lissovolik (2003);
Sinxayvoravong (2003); Aron et al. (2004) and Domac (2004) suggest that exchange rate
plays a crucial role in determining the volatility of inflation. Furthermore, expectation in
currency devaluation appears to be the most important factor fueling inflation pressure
(Himarios 1987; Goldfajn and Werlang 2000; Bilan and Siliverstovs 2005). Third, inertial
factors influenced from existence of wage contracts or rigidity adjustment of inflationary
expectations may be significant inflation components (Chopra 1985). Finally, discussed by
Bahmani-Oskooee and Domac (2002) and Sinxayvoravong (2003), dollarization leads to
velocity in inflation pressure given the government deficit financed by inflation tax.

Over the last ten years of economic development, Laos has experienced high and volatile
inflation (Appendix B: Figure 1). In mid 1995, the inflation rate went up to 30 per cent
related mainly to expansionary macroeconomic policies both fiscal and monetary policies
and depreciation in the exchange rate. The price velocity again with higher degree of
inflation during the era of Asian crisis in 1997 combined with expansionary fiscal policy in
1997/98 and 1998/99, peaked at 167 per cent in 1999. In dealing with price volatility,
tightening policies were introduced leading to inflation reduction.

The study on the factors affecting the fluctuation of inflation in Laos during 1992 to 2001
was carried out by Sinxayvoravong (2003). He found that inflation was affected by foreign
price, exchange rate, monetary base, dollarization, and income. Engle-Granger approach

5
was used for a single equation model to estimate one-step error correction model. However,
I find that his methodology missed the test of endogeneity, which might lead to invalidity
of the model estimation. In addition, I also find that he missed an important factor in
determining inflation process in Laos that is foreign interest rate. Therefore, this research
will include the foreign interest rate into the inflation model and will conduct endogeneity
test, in order to make his model more valid and accurate.

The process of modeling the price equation in Laos from 1992 to 2004 for this research
includes; firstly conducting the price model based on Sinxayvoravong framework (2003),
secondly, using econometric approaches as tools for estimating and testing the model: (i)
Augmented Dickey-Fuller (ADF) test of unit roots; (ii) Johansen co-integration test; (iii)
Engle-Granger Method – one-step error correction model – to estimate a single price
equation; and (iv) The Hausman edogeneity test.

The rest of this paper is organized as follows. Section 2 discusses findings of previous
research regarding determinants of inflation in emerging economies including Laos.
Section 3 briefly outlines the theoretical framework and inflation models. Section 4
presents data and estimation methodology. Section 5 reports the obtained results. Section 6
discusses and analyzes the results. Section 7 concludes.

Literature Review
Some researchers focused on the identification of the factors to determine the inflation
pressure. Despite the variation of using methods and study on countries, the common views
on inflation factors in transition economies are exchange rate, expectation of exchange rate,
fiscal factor and dollarization influence. Montiel (1989); Bailliu et al. (2003); Lissovolik
(2003); Sinxayvoravong (2003); Arong et al. (2004); and Domac (2004) found that
exchange rate plays a crucial role in determining the volatility of inflation. These
researchers argued that substantial effects of exchange rate on inflation process were the
results of high degree of dependency. However, Reyes (2004) found a low relationship
between exchange rate and price owing to the intervention of monetary authority under
inflation targeting economies.

Expectation on exchange rate influencing inflation process is another factor that has been
explored. Himarios (1987); Goldfajn and Werlang (2000); and Bilan and Siliverstovs
6
(2005) had a similar view that devaluation expectations appear to be the most important
factor fuelling price innovation. In respect of this finding, there are uncertain methods for
identifying the proxy for expectation. As a result, these researchers applied different
proxies such as Himarios; and Bilan and Siliverstovs used wage rate whereas Goldfajn and
Werlang used survey data for future exchange rate to calculate exchange rate expectation.

A further inflation factor is fiscal dominance. On the basis of study across countries in a
similar period (1960s-1990s) but different methods, Loungani and Swagel (2001) and
Fisher et al. (2002) argued in the same view that fiscal imbalance related to money growth
is possible to push the price up. However, Loungani and Swagel found that this
phenomenon will exist merely in countries with floating exchange rate regimes. In contrast,
study in Ukraine under a period of relative macroeconomic stability (1996-2002) of
Lissovolik (2003) and Bilan and Siliverstivs (2005) found money growth has a negligible
impact on inflation even they used different approach. Similarly, Sinxayvoravong (2003)
by using case study of Laos found that the monetary base is a weak relationship in both the
short and the long term. Conversely, under the period of high inflation in Ukraine (1993-
1995), Lissovolik found that the budget deficit with almost full financing from the
monetary authority led to broad money high co-integrating price instability.

Effects of dollarization on inflation process are also investigated due to dominancy of

foreign currency in emerging market economies. Bahmani-Oskooee and Domac (2002)
employing VARs models for Turkey from 1990 to 2001 and Sinxayvoravong (2003) using
the single equation for Laos between 1992 and 2001 affirmed that dollarization leads to
velocity in inflation pressure given the government deficit financed by inflation tax.
Nonetheless, Sinxayvoravong (2003) showed additional evidence that the relationship
between dollarization and inflation pressure appear strongly only in the short run, not in the
long term.

Model comparison is another aspect that has been focused in order to conduct appropriate
macroeconomic policies, apart from identification the inflation factors. However, the
findings are various depending on the countries and situations of studying. Bailliu et al.
(2003) testing three existing models – Mark-up model, Monetary equation and Phillips
curves – found the mark-up model is the best model to forecast inflation in the context of
Mexico, while money model did not appear to be useful in its current form and the Phillips

7
curves could not explain when it comes to forecast inflation. Lissovolik (2003) using VARs
estimation asserted similarly to Bailliu et al. that the mark-up model was fitted to the
framework of Ukraine under the stable phenomenon, though the money model was more
applicable under high inflation circumstance. Domac (2004) tested the model under
different exchange rate regimes in Turkey and suggested that the mark-up model was more
appropriate under fixed exchange rate regimes, whereas in respect to floating exchange rate
regimes the Phillips curves is better.

Based on empirical evidence, the general agreement on inflation factors for emerging
countries are possible to be (i) monetary factor related to the budget deficit; (ii) exchange
rate; (iii) exchange rate expectation; and (iv) dollarization influence. However, the strong
relationship between inflation and its factors depends on country episodes.

There is only one study applying the econometric approach with a single equation model to
determine the inflation dynamics in Laos from 1992 to 2001 (Sinxayvoravong 2003). His
analysis focused on identifying the effects of dollarization on inflation. He also concerned
other factors such as foreign price, exchange rate, money reserve and income. Even he
provided intuitive explanations of the macroeconomic variables affecting the inflation
process in Laos, he did not confirm the model by testing endogeneity. This is a crucial part
of testing the consistency of model estimators. Therefore, this paper will use Hausman test
to examine the existing of endogeneity in the inflation model. In terms of completeness of
the inflation model, Sinxayvoravong model did not consider foreign interest rate. On the
basis of transition economies as Laos that is dominated by some certain degrees of
dollarization and domestic interest rate is fixed, foreign interest rate becomes a choice for
resource allocations. In addition, the accepting foreign exchange of banking system makes
foreign interest rate more crucial role as a rate of return of storing foreign assets or an
opportunity cost of holding domestic assets. Therefore, this paper will take foreign interest
rate incorporating in the Sinxayvoravong (2003) framework.

There are two hypotheses for this research. First foreign interest rate is an important factor
in explaining the inflation process in Laos. Second the need to test endogeneity of
explanatory variables in order to achieve the validity of model.

8
Model Specification
Practically, inflation process is dynamics affected from various shocks. Many empirical
studies used structural models of inflation that consider all channels of feedback in
explaining inflation. However, it is a-theoretic due to less prior information (Gujarati
1995:749). Hence, it is less suited for policy analysis. Furthermore, on the basis of
underdeveloped financial system in Laos, few choices can be made for resource allocation.
Consequently, there is a limitation of inflation transmissions. Thus, it would be suitable to
conduct the model in single equation.

For inflation dynamic model in Laos, the research will use the inflation model of small
open-economy that popularly has been used in many studies of modeling inflation process
in transition economies (Himarios 1987; Lissovolik 2003; Sinxayvoravong 2003; Reyes
2004). This model assesses overall price in the economy by considering the effects of non-
traded and traded goods price. If the law of one price 1 holds and foreign interest rate is a
price for resource allocation2 , the single price model from Sinxayvoravong 3 (2003) will
present as:
log p t = β 1 log M t + β 2 log et + β 3 log y t + β 4 log f t + β 5 log p tf + β 6 it f (1)
where, log pt is the overall price in natural logarithm form;

log M t is monetary base in natural logarithm form;

log et is exchange rate of local currency (kip)/ US dollar, natural logarithm form;

log y t is gross domestic products (GDP) in natural logarithm form;

log f t is dollarization index in natural logarithm form;

log p tf is foreign price index in natural logarithm form; and

it f is foreign interest rate in natural logarithm form.

QTM provides the link between price and money moving in the same direction. Domestic
price development also responds positively with a change in exchange rate and foreign
1
Empirical exercise is performed PPP test by using FS test, the long-horizon approach. The results of PPP
test satisfy the assumption.
2
Domestic deposit interest rate almost all the time is less than inflation rate. So, it cannot be an incentive
choice for money demand in Laos. On the other hand, foreign interest rate (if ) seems to be an alternative
choice because banking system has been allowed to accept foreign currency from society in terms of deposit
and borrowing.
3
See his paper for more detail on the derivation of the model.
9
price level. This mechanism works through the ideas of purchasing power parity of open
economy. In contrast, Phillips curves present a trade-off between output and inflation
particularly in the short run. An increase in output reduces inflation. Capital mobility and
asset substitution show the link between foreign interest rate and traded good prices. When
foreign interest rate rises, foreign asset is more attractive. It leads to capital outflow and
then local currency depreciates. In addition, in case of dollarization environment, society
will shift to hold more foreign assets. High demand for foreign exchange push domestic
price higher through exchange rate depreciation.

Data and Estimation Methodology

Data Description
The data used in this analysis is taken from the Bank of Lao PDR and International
Monetary Funds (IMF). The estimated sample uses monthly data in the period from
January 1992 to December 2004. Money supply that indicates the movement of fiscal
budget deficit is defined as monetary base. Exchange rate devaluation is defined as parallel
exchange rate in unit of Kip per US dollar because the authority uses this rate to adjust the
official exchange rate. Dollarization factor is measured as a proportion of foreign deposit in
the baking system to broad money (Sahay and Vegh 1995 and Balino et al. 1999). Foreign
prices are weighted by 60 percent for Thai prices and 40 percent for US prices
(Sinxayvoravong 2003). Foreign interest rate is defined as an average value between Thai
deposit interest rate and US deposit interest rate. Dummy variables are included in the price
model corresponding to particular policy and scenario such as Financial Crisis (July-
December 1997) and dramatic tightening policy (April-September 1999). Monthly GDP is
interpolated from annual data averaged by 12 in each year 4 owing to the indifference
between actual GDP and its trend. Data descriptions are shown in Table 1 (Appendix A).

Estimation Methodology
Unit roots test
Examining the integrating order of series, Augmented Dickey-Fuller (ADF) test is
conducted with the auto-regressions, AR (p=13). The test is chosen on the basis of
following considerations: (i) Even though the sequences of price index and parallel
exchange rate jumped rapidly during the period of 1997-1999 in Figure 2 and 3 (Appendix

4
Estimated by author.
10
B) and then came back to the same trend as usual by the early 2000, there are no priori
reason to expect a structural change; (ii) According to Said and Dickey (1984), if data is
finite data it can infer that autoregressive integrated moving average, ARIMA (p,1,q) is
equivalent to ARIMA(p,1,0). Hence, AR (p) is applied for ADF test; and (iii) Lag lengths
are determined by Schwarz Bayesian Criterion (SBC) test with the maximum of 13 lag
lengths because monthly data should consider possibility lag lengths no less than 12 months
(Enders 1995:236).

Johansen co-integration test

If unit roots test suggest non-stationary series with indifference in integrating orders,
Johansen test approach is conducted to identify the long run equilibrium of variables in the
structural forms. This test can avoid the problems occurring from a single regression
(Enders 1995:385) such as: (i) There is no systematic procedure in the single regression
method because of separating estimation of the multiple co-integrating vectors; and (ii)
Two step of Engle-Granger procedure create problem because the estimated residual may
not appropriate to be a proxy for co-integration test due to the OLS properties.

The Johansen test procedures also consider deterministic specification and number of lag
lengths. Setting different deterministic will make the asymptotic distribution of likelihood
ratio (LR) test various. Unit root statistic test will provide this reference. Sufficient lag
lengths are determined on the basis of LR statistic tests 5 recommended by Sims in 1980
with traditional VARs approach 6 (Enders 1995:396-397). So, the estimated form of the
model to test co-integrating relations in the first differencing is
p −1
Δxt = A0 + ∑ π i Δxt −i + πxt − p + ε t (6)
i =1

The basic idea of this test is that if coefficient matrix ( π ) is of rank n, the vector process is
stationary. However, if rank ( π ) is equal to 1, there is a single co-integrating vector and the

5
LR test statistic: LR = (T − c )(log Σ r − log Σ u ) ;
Where, T is number of observations; c is number of parameters in the unrestricted system: c = pn+1, n is
number of equations in the system (n=6), p is number of lags; log Σ i is natural logarithm of the determinant
of Σ i , i = r, u. r is number of lag restrictions and u is number of lag un-restrictions. The null hypothesis of
restricted VARs model is under χ 0.05,df . (df = rn2).
2

6
Traditional VARs approach use stationary variables in the VAR model. So, VARs system is estimated by
level form as suggested by Sims in 1980.
11
expression πxt − p is the error-correction factor. For other cases in which 1< rank ( π ) <n,

there are multiple co-integrating vectors. The number of distinct co-integrating vectors can
be obtained by checking the significance of the characteristic roots ( λ ) of π . Two test
statistics can be conducted to test for the numbers of characteristic roots that are λ max and

λtrace statistic tests. It can calculate λ max and λtrace 7 statistic from the characteristic roots of
π.

Engle and Granger: Error Correction Models

Error correction model (ECM) is used in order to determinants of price and explaining their
dynamics of the economic model equation (5) if observed variables are non-stationary and
they are co-integrated (Engle and Granger 1987). If the obtained results from unit root tests
and co-integration test of Johansen approach are provide as Engle and Granger
representation theorem, then the short run dynamics of inflation can be described by ECM.
The model in general form presents as:
n n
Δ log pt = β 0 + ∑ β 1i Δ log pt −i + ∑ β ji Δχ t −i + γ 1 log pt −1 + γ 1+ j χ t −1 + ε t (7)
i =1 i =0

where χ t is set of explanatory variables and γ 1 is a speed of adjustment to log run

equilibrium. Equation (7) will be estimated by OLS estimation and the long run
relationship between price and independent variables can be derived from this short run
dynamic equation.

Assumptions:
(1) error term is white-noise process
E (ε t ) = 0; E (ε t ε t′ ) = Σ for all t, where Σ = {σ ij2 , i, j = 1,2,.......m} is mxm positive

definite matrix; E (ε t ε t ' ) = 0 for all t ≠ t ’ and E (ε t / xt ) = 0

7
Trace statistic for the null hypothesis of r co-integrating relations, while maximum eigenvalue statistic tests
the null hypothesis of r co-integrating relations against the alternative r+1 co-integrating relations. They are
n
computed as: λtrace (r ) = −T ∑ ln(1 − λˆi ) ; λ max (r , r + 1) = −T ln(1 − λˆr +1 )
i = r +1

Where, λ̂i is the estimated value of characteristic roots obtained from the estimated π matrix. T is the

number of usable observations. And r is the number of co-integrating equations.

12
 (2) χ t −i ’s are not perfectly correlation or no multi-correlation.

Hausman endogeneity test

OLS estimates will be biased and inconsistent if endogeneity presents. The Hausman
specification test of endogeneity is conducted for testing the independence between the
stochastic regressor and the disturbances. Granger causality may not appropriate because
the weak condition to obtain the condition of exogeneity8 (Enders 1995:315). In this paper
will apply the Hausman test proposed by Davidson and Mackinnon (1989), which carries
out the test by running an auxiliary regression. Based on the relationship in equation (5),
three exogenous variables are suspected, namely log M , log e and log f , will be tested
whether they present an endogeneity or not. Nested models and instrument variables
criteria 9 are considered. The test follows the step as: (i) identifying instrument variables:
lag terms in explanatory variables; (ii) regress three explanatory variables on other
explanatory variables ( log p f and i f ) and the instrumental variables, then save their
residuals; (iii) Include those residuals in the equation (5); and (iv) Jointly test the
coefficients of those residuals. If they are jointly significant, reject the null hypothesis of
exogeneity.

Empirical Results
Unit roots test results
Series are expected to have a time-variant mean due to trend movement in each series. In
addition, investigating autocorrelation from correlogram, all variables have slowly decayed
and Q- statistics provide significant of autocorrelation in each series. ADF test is used and
suggest the results that output series has trend stationary, I(0), whereas the other variables
have mean-reverting properties in the first differencing; I (1) process with intercept
(Appendix A: Table 2). Q-statistic from Box and Jenkins also shows correlation
coefficients decreasing of these non-stationary variables in the first differencing.

8
A necessary condition for the exogeneity of explanatory variables is that current and past values of
dependent variable do not affect these explanatory variables.
9
Obtaining a suitable set of instrumental variables that are both sufficiently uncorrelated with the stochastic
disturbance terms and sufficiently correlated with the relevant explanatory variables, T-test and F-test are
used to test the significance of the instruments. Moreover, the Hausman test apply with nested models, hence
each equation is one of the other.

13
Johansen co-integration test Results
Even Johansen test can detect differing orders of integration; it is good not to mix variables
with multiple integrating orders. As a result of ADF test, GDP is not included. Then, to
ensure the white-noise process of residuals, LR statistic test is conducted. As shown in the
Table 3 (Appendix A), under null hypothesis of restricted VARs model, the lower value of
LR test statistics than critical value ( χ 02.05,df ), which is more acceptable the restricted

model. Hence, up to 4 lag lengths, it produces acceptable model compared to the other
choices.

The Johansen co-integration test includes intercept (Ao), but no deterministic trend that is
determined by unit roots test. The LR test indicates setting 4 lags (p = 4). The test consists
of 6 non-stationary variables I (1) – domestic price index, monetary base, foreign interest
rate, foreign price index, and parallel exchange rate. So, equation (6) is estimated. Then, the
result from λtrace statistic suggests that the vector process has less than or equal to four co-

integration vectors, whereas that of from the λ max statistic provides merely 3 co-integrating
equations at 95 per cent critical value (Appendix A: Table 4). As such case, the results of
λtrace and λ max are conflict. Enders (1995) suggests that λ max test is better than λtrace test
due to the sharper alternative hypothesis. Therefore, it can specific the number of co-
integrating vectors as 3 equations.

The error correction model results

As a result of non-stationary I (1) process in each series and co-integrating relations, the
error correction model is estimated in order to capture the long run relationship of price
instability. Even ADF test and Johansen test provide different lag lengths results, but
Johansen test done is to verify the co-integration of multivariate non-stationary. On account
of VARs method, it considers effects of all series in the whole systems, whereas ADF test
carries out the test in particular series for identifying the integrating order of univariate.
Thus, to avoid misspecification, this paper will apply lag lengths outcomes from Johansen
test. As a result, the error correction model is estimated in the first differencing form with
up to four lags. The short-run dynamics presents in the specific form as:

14
 4 4
Δ log pt = β 0 + ∑ β 1i Δ log p t −i + ∑ ( β 2i Δ log M t −i +1 + β 3i Δ log ptf−i +1 + β 4i log et −i +1
i =1 i =1

+ β 5i log p f
t − i +1 +β i f
6 i t − i +1 ) + γ 1 log p t −1 + γ 2 log M t −1 + γ 3 log ptf−1 + γ 4 log et −1
+ γ 5 log f t −1 + γ 6 it f−1 + ε t (8)
Long-run relation can be derived from the short-run dynamics as:
β0 γ γ γ γ γ
log pt = + 2 log M t + 3 log ptf + 4 log et + 5 log f t + 6 it f (9)
− γ1 − γ1 − γ1 − γ1 − γ1 − γ1

OLS estimate is applied for this one-step error correction model, equation (8). In this stage,
dummy variables for Asian financial crisis during July to December 1997 (D1) and
tightening monetary policy from April to September 1999 (D2) are incorporated in the
equation (8) in order to capture the effects of dramatically change. Furthermore, on account
of consistency, it is sensible to include these dummies placed the issue of omitted relevant
variables. The result is presented in Table 5 (Appendix A).

The short run dynamic model has a sensible statistic test. All coefficients are significant
and reasonable explaining the model by approximately 77 percent. Durbin-Watson statistic
shows the overall model serially uncorrelated. However, not all signs have an intuitive and
plausible. Clearly, dummy variables for Asian Crisis in 1997 and tightening monetary
policy in 1999 have apposite signs from expectations.

Therefore, the model will be examined for its adequacy. It also looks for remedies such as
omitted an important variable or have used the wrong function form. To determine whether
model inadequacy results from one or more of these problems, various methods to test
residual performance will be used. The results of the diagnostic test (Appendix A: Table 6)
suggest that the error term fulfill the classical assumptions. In specific, Cramer-von Mises
(W2) and Anderson-Darling (A2) test cannot reject the null of normal distributed error at 1
per cent significant level (Appendix B: Figure 4). In addition, LM test for serial correlation
and auto-regression conditional heteroskedasticity (ARCH) also depicts the satisfied
residuals that cannot reject the null of no serial correlation and no ARCH only up to order
1. In addition, the diagnostic test for model specification of RESET cannot reject the null of
homoskedasticity, independence of regressors and the correct of model specification up to
two fitted values. CUSUM test for the stability of error square also shows moderately stable
(Appendix B: Figure 5).

15
On the basis of the diagnostic tests, the short run dynamic model of inflation provides the
validity of outcomes. The adjustment coefficient of error correction ( log pt −1 ) for long run
equilibrium shows the intuitive sign with adjustment speed almost 6 months that is similar
to Sinxayvoravong results (2003). This result can reflect through the inertia in inflation that
100 percent change in price index in three months ago still influences the current change by
around 32 per cent, regarding to the effects of other explanatory variables.

As an expectation, exchange rate and foreign price are strongly significant having
contemporaneous effects on the price adjustment particularly foreign price effect. Precisely,
the elasticity of current price differencing with respect to that of exchange rate and foreign
price are 0.3 per cent and 2 per cent, respectively. This implication clearly reflects the
strong dependence of Lao economy on abroad.

Surprisingly, dummy for Asian crisis shows the negative impact on price. It indicates that
even there is high dependency; negatively external impact does positively influence Lao
economy. On the other hand, tightening monetary policy seems ineffective due to the
positive relation between price and the policy. These consequences differ from
Sinxayvoravong outcome (2003).

Holding constant the effects of other factors, current effect of monetary factor is
unexpectedly small. The current price elasticity with respect to current money base is
merely about 0.06 per cent. Dollarization influences and foreign interest rate present the
different outcomes. While, as an expectation, dollarization index shows positively effect on
current domestic price, foreign interest rate affects negatively.

Long-run price equilibrium

The speed of adjustment coefficient, -0.23, shows the consistency in long-run relationship
(Enders 1995:371). So, it can derive the long-run equilibrium from the short-run relation in
Table 5 (Appendix A) as:
log p t = −7.906 + 0.892 log p tf + 0.173 log M t + 0.785 log et − 0.36 log f t + 0.02it f (10)

This long-run relationship is rational economic explanation. All signs are intuitive and
plausible. Specifically, factors from external influences such as foreign price and foreign
interest rate explore significant in terms of economic intuition and magnitudes particularly

16
foreign price. For instance, with considering the other effects, an increase in foreign
inflation rate by 100 per cent raises domestic inflation by almost 90 per cent. Beside that an
increase in foreign interest rate by 100 percentage point raises domestic inflation by around
2 per cent. Similarly, depreciation in local currency by 100 per cent boosts inflation up by
about 79 per cent regarding to other effects. These statistic relationships do not only
meaningful in economic intuition; they also reflect a high integration of Lao economy with
abroad.

Even monetary factor has a consistent sign in relation to inflation instability; it has small
impact on domestic price by only 17 per cent. This effect is possibly dominated by foreign
price and exchange rate factors, which show the strong dependency of Lao economy. In
contrast to the short run outcome, dollarization index in long run equilibrium has reverse
relation to inflation rate. The increase in the level of dollarization leads to the reduction in
inflation as similar to Sinxayvoravong results (2003).

Hausman Endogeneity Test Results

The suspected variables as log M , log e , and log f regress on its exogenous and
instrument variables regarding to significant test for coefficients. The relationships present
as:
log et = α 0 + α 1 log p tf + α 2 log p t −1 + α 3 log et −1 + ν t (11)

log M t = φ 0 + φ1 log p tf−1 + φ 2 log f t −1 + φ 3 it f−1 + φ 4 log M t −1 + ϑt (12)

log f t = δ 0 + δ 1 log p tf−1 + δ 2 log et −1 + δ 3 it f + δ 4 log M t −1 + δ 5 log f t −1 + ω t (13)

Artificial model (14) for Hausman test recommended by Davidson and Mackinnon (1989)
is constructed on the basis of the relationship in equation (5) 10 and estimated residuals,
νˆt ,ϑˆt and ωˆ t obtained from (11), (12) and (13) respectively.

log pt = ϕ 0 + ϕ1 log ptf + ϕ 2 log et + ϕ 3 log M t + ϕ 4 log f t + ϕ 5 it f + ϕ 6νˆt + ϕ 7ϑˆt + ϕ 8ωˆ t + ε t

(14)
The model (14) is estimated by OLS approach that provides the statistic value for testing
being endogenous of explanatory variables. The Hausman test results are illustrated in table
7 (Appendix A). Residuals of three suspected explanatory variables are jointly significant
rejecting the null of exogeneity in favor of endogeneity. However, two residuals of

10
GDP does not include because the different order of intergration.
17
exchange rate and dollarizarition index together cannot reject the null of exogeneity.
Therefore, it can conclude that the model (5) may face endogeneity problem particularly
monetary factor (reserve money) cannot meet the condition of exogeneity. This problem
will lead to the classical assumptions violated with inconsistency.

Discussion and Analysis of Results

The overall results indicate that the single inflation model is plausible to interpret inflation
phenomenon in Laos. Both the short-run and long-run relationships are meaningful to cite
the intuitive explanations for price instability. On the basis of the results and Laos
situations, five important points are worthwhile for this discussion. First, the substantial
effects of foreign price and exchange rate on inflation process in Laos express the
explanatory power. Clearly, this outcome closely links to the high degree of international
integration of small-open economies as Laos.

Second, the significantly reserve money entirely reflects the underlying the phenomenon of
Lao economic development. It shows the evidence of fiscal dominance matters particularly
in 1995 and during 1998 to 1999 that monetary base requires to be adjusted endogenously
to fulfill the expansionary fiscal policy. This economic phenomenon is known as Non-
Recardian regime (Walsh 2003). However, even monetary base depicts positively
significant but relatively low effects compared to foreign price and exchange rate. One
reason can be the dominant effects of foreign price and exchange rate. Another reason is
that the monetary policy actions have performed a relatively-fixed domestic interest rate
hence money needs to adjust endogenously to ensure the economy on the track of
development target (controlling inflation).

Third, even foreign interest rate changes the sign of correlation from negative in the short-
run to positive in the long-run relationship; it results of estimation method of the error
correction model that can be varied. This method has considered the first differencing as
dependent variable in order to address the issue of non-stationary variables. However,
positive relationship in the long-run is more considerable. The positive correlation between
foreign interest rate and domestic price index reflects the evidence of asset substitution
particularly in terms of foreign exchange. Domestic price will be pulled up through two
major channels, namely dollarization influences and traded good prices.

18
The first channel, on the basis of less financial development, there is less choice for asset
allocations. Thus, under foreign exchange officially held by public and deposited at the
banking system, higher foreign interest rate is attracted by public to increase their demand
for foreign currency 11 . Asset substitution will shift domestic assets to foreign assets. The
high demand for foreign exchange will raise a higher degree of dollarization both in
banking system and non-banking systems. It leads to lower credibility of local currency.
The depreciation in exchange rate will push the imported price in unit of local currency
more costly. Then, the general price level will go up. The second channel, on account of
Fisher identity, an increase in foreign interest rate will infer that foreign price will go up as
constant real rate of return. Clearly, traded good prices will positively respond and lead to
the general price in domestic rising.

It shows that even low magnitude, foreign interest rate has the crucial relationship on
inflation process by working through traded good prices and dollarization 12 . Therefore,
Sinxayvoravong paper that missed this variable may provide incomplete explanation of
inflation process in Laos.

Fourth, Inflation inertia appears significantly in the short-run price equation. Even price
liberalization implemented after market reform, but many price products still continue
under control or carefully managed. It might be the effects of price controlling on strategy
products mainly relating to the traded goods. For instance, fuel products with price ceiling
are the major import goods. Some domestic goods are also under control such as service fee
of electricity, water supply and some agricultural products. In banking system, interest rate
is set relatively fixed. This controlling leads to slowly adjustment of current price index.

The final result is Hausman test that shows an evidence of single equation model is
experiencing inconsistency because monetary base shows the significant interrelationship
with price index. This finding of the Hausman test for endogeneity also reflects the policy
actions that affect reserve money responding endogenously to ensure those policies being

11
Doolarization is associated with an increase in banking spreads because an increase in deposit dollarization
is related to an increase in offshore deposits (Honohan and Shi 2001).
12
Bearing in mind, the long-run relation of dollarization has negative impacts on price index. Sinxayvoravong
(2003) explained that high dollarization level implies low possibility of the government to generate inflation
through inflation tax of financing budget deficit. It makes inflation lower. He also pointed that it may be just
the simple relationship of these two series.
19
able to aim their targets. Therefore, it would violate the results of Sinxayvoravong with less
validity (2003).

Nevertheless, in the short-run dynamics model, it is exclusively composed the difference in

lag variables and its own lags. So, the implications from the short-run model still remain
validity and adequacy. It implies that the long-run equation derived from the consistent
estimators will provide valid outcomes (Enders 1995).

In terms of methodology, the substantial changes in particular period normally lead to

heteroskedasticity problem and instability of residual. These problems exist when it comes
to the divergence in data series. Figure 5 (Appendix B) shows the cumulative sum
(CUSUM) of the recursive residuals going outside the area between the two critical lines
particularly in the first period of the sample. On the other hand, after the critical period,
financial crisis and stabilizations, this problem has no longer substantial effect and CUSUM
of residual again move back to lie inside the lines. RESET test also confirms no
heteroskedasticity of residual (Appendix A: Table 6).

These valid implications are presented underlying the data structure, theoretical framework
and econometric methodology. Clearly, data require the critical considerations with reliable
collection system and the substantial changes. Basic ADF 13 test for non-stationary in series
sequences is sufficiently valuable to identify the existing of unit roots. However, output 14
with deterministic trend stationary possibly results from the basic approach of monthly
interpolation (average by 12).

The model framework and the estimation methodology lead to applicable outcomes for
reality in Lao economy. The model is set on the basis of the small open economy in the
period of transitional market that is possible to have a high degree of dependency.
Therefore, all explanatory variables are significantly correlated with price level. However,
it is important to note that one-step estimation method of error correction model with the
first differencing as a dependent variable may give the results variation. The short-run
dynamic price model may provide various signs that differ from the economic intuition

13
Econometric exercises to test unit roots by Perron’s test for structural change and ADF-detrending provide
similar results to basic ADF test.
14
If unit roots test provides incorrect result, this model is not possible to face the problem of omitting relevant
variables. According to the econometric exercise, output does not show significant correlation with price
index.
20
such as foreign interest rate and dummy variables for Asian financial crisis and tightening
monetary policy.

These variations tend to appear with the longer lag lengths. So far the longer lag lengths
incorporate in the model mainly because of correcting auto-correlations. Furthermore, the
sufficient lag lengths will ensure the adequacy of the short-run model that will bring about
the consistency of long-run relationships.

Conclusion
This paper is aimed at exploring dynamic relationship between inflation and five other
macroeconomic variables: money growth, exchange rate, foreign price, dollarization and
foreign interest rate. This analysis bases on one-step error correction model of Engle-
Granger that similar to the previous paper in Laos. However, this paper makes two new
principal contributions for quantitative analysis in Laos. First, awareness of the problem
from the single equation model, endogeneity test by Hausman test method is implemented.
The implication is that money growth shows an evidence of deteriorating exogeneity
conditions, in which the monetary base has substantial interrelationship with inflation.
Second, foreign interest rate newly introduced into the price single equation; in the long-run
it expresses the positively significant effects on inflation through the channels of traded
good prices and dollarization.

The other substantial consequences present as (i) there is an evidence of ample influence of
foreign price and exchange rate on inflation dynamics in Laos. This outcome associates
with a high degree of Lao economic dependency; (ii) even the effects of money growth on
price dynamics are weak owing to the monetary policy actions, it is important to explain the
role of fiscal policy; (iii) dollarization plays positive role in determining the shot-run
inflation process in Laos, but not in the long-run; and (iv) the evidence of substantial
inflation inertia can be attributed to high degree of price control in the country.

Even there is an issue of endogeneity of explanatory variables; the short-run dynamic price
model remains validity and consistency due to its lags and the differencing in lag variables
as the components of explanatory variables. The long-run price equilibrium derived from
the short-run model should produce consistent results. However, seeking for instrument

21
variables or changing methods of estimation from considering one-side effect to
interrelationships of system equations should be considered in the next step of study.

This paper also considers the limitations in the research. First, according to unknown the
form of the data-generating process whether AR (P) or MA (q) or ARIMA (p,I,q), ADF test
may mislead. Second, if some series sequences have structural change, ADF test will be
biased and tends to accept the null of unit roots. Third, it may true that our series may have
trend stationary process. So it could lead to misspecification of inflation dynamic model.
Fourth, the short-run model may face the problem of third factor argument because the
evidence of dropping either one or another variable will make the remaining variables have
low power of test (Appendix A: Table 8). Fifth, the long-run equilibrium may misinterpret
in terms of significant results even it is the outcome of consistent derivation from the short-
run dynamics. It requires specifying the asymptotic statistic references. Sixth, limitation of
variables may provide inappropriate instrument variables that will lead to incorrect results
of the Hausman test. Finally, forward-looking factor is not considered, it may lead to model
inconsistency.

Taken together the limitations, structural system equations is a competitive choice for the
next study, in which it can deal with problem such endogeneity of explanatory variables
and less chance to omit relevant variables.

22
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Loungani, P. and Swagel, P. 2001., ‘Sources of Inflation in Developing Countries’, IMF
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24
Appendix A

Table 1 Descriptive statistics for main series

Variables Mean Maximum Minimum Std. Dev. No. of Obs

log p 3.614 5.036 2.163 1.078 156

log p f 4.527 4.693 4.300 0.118 156
log M 5.473 7.350 3.254 1.268 156
log e 7.962 9.302 6.583 1.165 156
if 5.296 9.795 1.025 2.647 156
log f -0.644 -0.178 -1.313 0.337 156
log y 1.993 2.339 1.617 0.228 156

Source: Bank of the Lao PDR. (BOL), IMF: International Financial Statistics (IFSs) and author estimates.

Table 2 Unit root tests: Augmented Dickey-Fuller (ADF) test

Level First differences

Variables ADF-test statistic Lags Variables ADF-test statistic Lags
Log(P) -0.6579 2 Dlog(P) -4.5275*** 1
Log(MB) -0.4475 2 Dlog(MB) -7.851*** 1
1
Log(f) -1.3102 Dlog(f) -12.9994*** 0
Log(pf) 1 0
-2.4259 Dlog(pf) -8.8747***
if 1 0
-0.545245 Dif -9.604693***
log(MER) 1 0
-0.5777 Dlog(MER) -7.3506***
Log(y) # -4.841***
1

Note: test critical value with intercept at 1per cent, 5 per cent and 10 per cent provides significant level as -
3.4731; -2.8802 and -2.5768. # depicts that output is tested with deterministic trend and critical value at 1
per cent, 5 per cent and 10 per cent is -4.02, -3.44 and -3.14 respectively. The superscript ***; ** and *
denotes rejecting null hypothesis (unit roots) at 1 per cent; 5 per cent and 10 per cent.

Source: Author’s calculation

25
Table 3 Likelihood ratio test: lag lengths test

Null P=8 against P=4 against P=2 against P=1 against P=1 against P=3 against
p=4
hypothesis p=12 p=8 p=4 p=2 p= 4
LR 61.009*** 114.819*** 128.478 28.354*** 154.016 81.551
Df 144 144 72 36 108 36
χ 02.05,df 124.34 124.34 92.8 51 124.34 51

Note: p is number of lags. The superscript *** denotes that cannot reject the null of restricted VARs model at
5% critical value.

Source: Author’s calculation

Table 4 Johansen test: the λ max and λtrace tests

Null hypothesis Alternative hypothesis 95% Critical Value

λtrace tests λtrace value
r=0 r>0 176.848 103.847

r ≤1 r >1 116.263 76.973

r≤2 r>2 69.657 54.079

r ≤3 r >3 35.465 35.193

r≤4 r>4 15.258*** 20.262

λ max tests λ max Value

r =1 40.857
r=0 60.584
r=2 34.806
r =1 46.607
r =3 28.588
r=2 34.191
r=4 22.299
r =3 20.207***

Note: r is number of co-integrating relations (the co-integrating rank).

The superscript *** denotes that cannot reject the null hypothesis at 5 per cent critical value.

Source: Author’s calculation

26
Table 5 Short run dynamic estimation, dependent variable is Δ log pt

Variable Coefficient Std. Error t-Statistic

Constant -1.812*** 0.324 -5.591

Δ log p tf 1.926*** 0.561 3.434
Δ log p f
t −2 -1.069* 0.594 -1.800
Δ log M t 0.059** 0.029 2.033
Δ log et 0.294*** 0.039 7.466
Δ log et − 2 -0.218*** 0.050 -4.335
Δ log et −3 -0.132*** 0.043 -3.099
* Δ log et − 4 -0.180*** 0.040 -4.454
Δit f−3 -0.013** 0.005 -2.581
Δ log pt − 2 0.322*** 0.066 4.849
Δ log f t −1 0.065* 0.036 1.786
f
log p t −1 0.204*** 0.076 2.693
log M t −1 0.039*** 0.012 3.191
log et −1 0.179*** 0.022 8.329
f
i t −1 0.005** 0.002 2.516
log f t −1 -0.083*** 0.022 -3.799
log pt −1 -0.229*** 0.027 -8.556
D1 -0.033*** 0.009 -3.614
D2 0.037*** 0.009 3.901
R-squared 0.774788 F (13, 137) 25.22861
Adj. R-squared 0.744078 Prob(F-statistic) 0.000
RSS 0.038599 DW statistic 2.059396

Note: the superscripts ***, ** and * denote rejection at 1 per cent, 5 per cent and 10 per cent critical values.
*it includes based on the empirical work to make the error correction model well-behave.

Source: Author’s calculation

27
Table 6 Diagnostic tests for the short run dynamic price model, equation (8)

Tests Methods Statistic test Probability

Normality test Cramer-von Mises (W2) 0.157 0.019

Anderson-Darling (A2) 0.948 0.017
Serial Correlation LM test up to order 1 F(1, 131) 0.183 0.669
Obs*R-squared 0.211 0.646
ARCH Test up to order 1 F (1,148) 1.089 0.298
Obs*R-squared 1.096 0.295
Ramsey RESET Test: up to 2 fitted terms F (2,130) 1.972 0.143
Log likelihood ratio 4.513 0.105

Source: Author’s calculation

Table 7 Hausman test for edogeneity

Null hypothesis Statistic tests P-value

νˆt =ϑˆt = ωˆ t = 0 F (3,146) = 3.922*** 0.0099

νˆt =ωˆ t = 0 F (2, 146) = 1.030 0.359
νˆt =ϑˆt = 0 F (2,146) = 5.655*** 0.004
ϑˆ = 0
t F (1,146) = 7.998*** 0.005

Note: the superscripts *** denotes rejection at 1 per cent critical values.

Source: Author’s calculation

28
Table 8 The short-run dynamic model with dropping Δ log p tf

Variable Coefficient Std. Error t-Statistic

Constant -1.982*** 0.346 -5.726
Δ log p tf− 2 -1.731*** 0.621 -2.789
Δ log M t 0.049 0.032 1.511
Δ log et 0.299*** 0.042 7.050
Δ log et − 2 -0.241*** 0.054 -4.497
Δ log et −3 -0.128*** 0.045 -2.826
* Δ log et − 4 -0.215*** 0.043 -5.007
Δi f
t −3 -0.0002* 0.002 -0.125
Δ log pt − 2 0.347*** 0.072 4.813
Δ log f t −1 0.064 0.039 1.647
f
log p t −1 0.229*** 0.079 2.867
log M t −1 0.039*** 0.013 3.085
log et −1 0.193*** 0.023 8.480
it f−1 0.005*** 0.002 2.795
log f t −1 -0.095*** 0.024 -4.015
log pt −1 -0.242*** 0.028 -8.553
D1 -0.028*** 0.009 -2.871
D2 0.036*** 0.011 3.320
R-squared 0.743 F (1, 129) 21.966
Adj. R-squared 0.709 P_value 0.000
RSS 0.044 DW statistic 1.828

Note: the superscripts ***, ** and * denote rejection at 1 per cent, 5 per cent and 10 per cent critical values.
*it includes based on the empirical work to make the error correction model well-behave.
The difference in monetary base, dollarization and foreign interest rate has lower power of test in the short-
run model with dropping Δ log p t comparing to the results from table 5.
f

Source: Author’s calculation

29
Appendix B

Figure 1 inflation rate in Laos from 1991to 2004

Yearly Inflation rate

180
160
140
120
100
80
60
40
20
0
M1 1990

M3 1991

M5 1992

M7 1993

M9 1994

M11 1995

M1 1997

M3 1998

M5 1999

M7 2000

M9 2001

M11 2002

M1 2004
Source: Bank of the Lao PDR and IMF

Figure 2 General Price Innovation, 1992-2004

5.2

4.8

4.4

4.0

3.6

3.2

2.8

2.4

2.0
1992 1994 1996 1998 2000 2002 2004

LNP

Source: Author’s calculation

30
Figure 3 Exchange Rate, 1992-2004

9.5

9.0

8.5

8.0

7.5

7.0

6.5
1992 1994 1996 1998 2000 2002 2004

LNE

Source: Author’s calculation

Figure 4 Normal distribution of residuals

Kernel Density (Normal, h = 0.0045)
32

28

24

20

16

12

0
-.04 .00 .04

RESID01
Normality of Residual

Source: Author’s calculation

Figure 5: Cumulative Sum of Squares of Recursive Residuals

1.2

1.0

0.8

0.6

0.4

0.2

0.0

-0.2
1999 2000 2001 2002 2003 2004

CUSUM of Squares 5% Significance

Source: Author’s calculation

31