Economics of Planning 35: 205–219, 2002.

205
© 2003 Kluwer Academic Publishers. Printed in the Netherlands.

Wage and Price Inflation in Poland in the Period of

Transition: The Cointegration Analysis

ALEKSANDER WELFE and MICHAŁ MAJSTEREK

Chair of Econometric Models and Forecasts, Institute of Econometrics and Statistics,
University of Ladz, 41 Rewolucji 1905r, 90-214 Lodz, Poland

Received 21 December 1999; accepted in revised form 24 January 2002

Abstract. The paper focuses on the long run relationships between wages, prices and labour pro-
ductivity in the Polish economy by applying recent developments in the field of multivariate cointeg-
ration analysis. We followed modeling strategy which is suggested by Greenslade et al. (1999) and
present all stages of the analysis which leads to the fully economically identified system of equations
representing long run relationships. The investigation is based on the quarterly data from 1992.1
to 1999.2 which covers the period of transition of the Polish economy from the centrally planned
system towards the market one. Basing on the empirical results we can argue that wages (costs) were
one of the main forces driving inflation in Poland during that period. Also labor productivity proved
to be stimulated by the increase of the real wages. On the other hand the hypothesis concerning the
relationship between wages and unemployment was rejected by the data.

Key words: cointegration analysis, inflation, Poland, wage

1. Introduction
Economic hypotheses usually relate to the long-run. However, direct observation
(measurement) of relevant relationships is rather impossible due to the short-run
fluctuations which, usually, are not regular, although are not random since they
result from particular mechanisms present in the system. Consequently, empirical
investigation must lead to the decomposition of economic behaviour into short
and long-run reactions, distinguishing ‘true’ relationships from spurious correla-
tions. Therefore in the presented study cointegration was used as methodological
framework for the analysis.
Most of the macroeconomic variables are non-stationary while some of them
tend to drift together over time. This means that the discrepancy between such
variables cannot grow indefinitely. Very good examples of such relationships are
prices, wages and labour productivity or real interest rate, inflation and exchange
rate.
The SVAR model takes care of non-stationarity of the variables eliminating their
common stochastic trends, and, at the same time, utilises all relevant economic the-
ory via restrictions imposed on parameters. This leads to the (linear) combination
of variables of interest which is stationary, ergo to the system of interdependent
206

equations. Such a system is exactly what is formulated by classical econometrics

as simultaneous equation model — it defines long-run, stationary relationships.
Cointegrating relations are typically linear, but it is easy to imagine that also non-
linear functions of non-stationary variables can produce stationarity. This kind of
generalisation is possible and relatively easy within the SVAR framework (see Hall
et al., 2000).
Properly used SVAR typically proves its effectiveness, and leads to many sound
economic conclusions as it was in our case. We were able to establish important
long-run relationships between prices, wages, and labour productivity in the period
of transition of the Polish economy. The results show that there is an empirical
support for numerous economic hypotheses (e.g., the unit elasticity of wages with
respect to prices).

2. Structural VAR
The vector autoregressive model, VAR can be written as:

S
y(m)t = y(mt )t −s s + ξ(m)t , (1)
s=1

where: y(m)t = [y1t . . . yMt ] is vector of M variables, s = [πij(s)] is M × M

matrix of parameters, ξ(m)t = [ξ1t . . . ξMt ] is vector of white noise disturbances,
m = 1, . . . , M; s = 1, . . . , S; t = 1, . . . , T .
Algebraic transformation of the above equation gives an unrestricted version of
vector error correction model, VECM:

s−1
y(m)t = y(m)t −1  + y(m)t −s s + ξ(m)t , (2)
s=1

where:


S
= s − I,
s=1

s
S = − s .
S=i+1

R independent cointegrating relationships between variables ym , where 0 ≤ R <

M, implies that the long-run matrix  = −S can be decomposed as:

 = BAT , (3)
 207

where:
B = [β(m)1 β(m)2 . . . β(m)R ]M×R ,

A = [α(m)1 α(m)2 . . . α(m)R ]M×R

Matrices  and B are of rank R. Columns of matrix B represent cointegrating vec-
tors while columns of matrix A-loading weights related to cointegrating vectors.
The weight close to zero proves insignificant influence of cointegrating relationship
on particular variable. The variable is weakly exogenous (in the long-run) if the
relevant row of matrix A contains exclusively zeros.
The above result allows to reformulate (2) giving:


S−1
y(m)t = p(m)t −1AT + y(m)t −s s + ξ(m)t , (4)
s=1

where p(m)t −1 = y(m)t −1 B.

It should be noted that all variables appearing in Eq. (4) are stationary: y(m)t ∼
I (0) since by initial assumption y(m)t ∼ I (1), and also p(m)t −1 ∼ I (0) because
variables are cointegrated.
The VECM represented by (3) is a reduced form of the structural VAR (SVAR):


S−1
˜ +
y(m)t A0 = y(m)t −1 y(m)t −s AS + ζ(m)t , (5)
s=1

where  ˜ = A0 , As = s A0 , and ζ(m)t = ξ(m)t A0 . Matrix  ˜ can be analogously to

(3) decomposed on fully structurally identified M × R matrices B̃ and Ã, = ˜ B̃ÃT .
The identification of the above system includes the identification of contem-
poraneous coefficient matrix A0 which defines both marginalization of the model
and simultaneous relationships between endogenous variables, and the long-run
coefficients included in matrix B̃. The identification of matrix As (related to the
dynamic part of the model) can take the form of restrictions on the dynamic path
of the model (parameters included in s ) and/or on the (weak) exogeneity of the
variables (i.e., restrictions on α(m)r ). It should be stressed, however, that the identi-
fication of A0 does not solve the problem of B̃ identification, since B̃ÃT = BAT A0 .
The identification of B̃ involves restrictions on the cointegrating vectors (i.e., on
β(m)r ) and/or on α(m)r (see the discussion in: Hall and Zonzilos (1999)).
The exact identification of the long-run structure requires R 2 restrictions (see
Mizon, 1993; Pesaran and Shin, 1994). If the number of restrictions k < R 2 the
system is underidentified, if k > R 2 — it is overidentified. In the last case the
restrictions can be tested by the standard likelihood ratio test (wider discussion in
Hendry and Mizon, 1993; Johansen, 1995):
 R 



R
Q=T ln(1 − λ̃r ) − ln(1 − λ̂r ) , (6)
r=1 r=1
208

where λ̂r λ̃r are eigenvalues corresponding to respectively unrestricted and restric-
ted cointegrating vectors.
The results obtained by Greenslade at al. (1999) show that although asymp-
totically it does not matter if the overidentifying restrictions are tested before de-
termining the dynamic structure of the model, in limited samples of the common
sizes, the power of the tests is low. Therefore the following modelling strategy was
suggested which is generally applied in this paper:

(i) determine the cointegrating rank,

(ii) determine the split between endogenous and weakly exogenous variables on
the basis of economic theory and verify it by testing matrix A,
(iii) find a parsimonious representation of the dynamic structure of the model,
(iv) impose all other restrictions on long-run coefficients β(m)r and weights α(m)r
and in case of overidentifying restrictions test them.

3. Inflation in the period of transition in Poland

The 1980s was the period of centrally planned economy which was characterised
in Poland by deep disequilibrium in the consumer goods market associated with
administrative price and wage controls (estimates of the excess demand can be
found in Welfe, 1989). It should be emphasized, however, that the role of the
central planner systematically had been declining, and at the end of the decade
the so called ‘market reforms’ were introduced. The collapse of the old political
system in 1989 enabled the start of the transformation towards a market economy.
Relaxation of foodstuffs prices in the mid-1989 and nearly full liberalization of
prices due to liquidation of the subsidies paid to the state-owned enterprises in
1990 brought about a hyperinflation: in 2 years cost of living index increased 12
times. Later, the inflation declined to 20% in 1996 and to 11% in 1998. This was
the result of several anchors which were introduced under the so called ‘stabiliz-
ation program’ among which one of the most important was wage indexation. An
indexation coefficient set by the Council of Ministers was kept constant (at the level
of 0.8) until 1995. It was the main economic instrument which helped to prevent
from overcompensation for cost of living increase (the estimates show that in the
years of centrally planned economy the elasticity of wages with respect to prices
was exceeding unity, see Welfe (1991)). In practice, within six to eight quarters
the equilibrium was regained in the most consumer goods markets. Increasing
confidence in government and banking institutions additionally helped to suppress
inflation (see analysis in Gomulka, 2000). Consequently the system changed from
typical supply-driven shortage economy (see classical work of Kornai, 1980) into
increasingly demand-constrained. However, very restrictive fiscal and monetary
policies resulted in unemployment rates exceeding 15% at the end of 1994 and
remaining on the levels above 10% in the second half of 1990s. The variation of the
 209

Figure 1. Main economic indicators: sample, 1990.1–1999.2

officially reported unemployment rate is, however, the result of frequently changed
legal regulations. All above explains why we limited the sample to cover the period
starting from the second quarter of 1992 (see Fig. 1).
After restrictive wage taxes were abolished, agreements between the represent-
atives of the government, entrepreneurs and trade unions on the maximum level of
real wage growth started to operate since 1995. In those negotiations the change
of cost of living index has been always used as the major argument. Recent devel-
opments in Poland prove that the economy still suffers from the cost-push infla-
210

tion. Wages and costs of imported raw materials (oil among others) play the most
significant role in this process.
Therefore the presented study is devoted to the problem of wage and price
dynamics and the role of other factors in determining inflation.
During the last decade Poland was led by different governments representing
opposite political options. Although the declared goals of the economic policy
have been changing, basic strategies remained the same. There were also many
similarities in the instruments and the way they were applied. For these reasons we
kept the parameters constant over the whole sample period.

4. The model
As a starting point, it was accepted that real earnings depend on productivity and
unemployment whilst themselves they can affect productivity and also inflation if
their increases are not compensated by productivity growth. Inflation should also
react negatively to other costs increases which include costs of imported inputs
(raw materials and intermediate products). The wage indexation mechanism was
generally considered as one of the main determinants of inflation and its persist-
ence, however, its impact depends on the existing indexation clauses. The long-run,
structural (static) model embodying above postulates can be written as follows (the
short-run version of this model is analysed in Osiewalski and Welfe, 1998):
wt = γ01 + γ21 pt + γ31 zt + γ61 Ut + ξwt (7a)

pt = γ02 + γ12 wt + γ32 zt + γ42 kt + ξpt (7b)

zt = γ03 + γ13 (wt − pt ) + γ53 gt + ξzt (7c)

where γij , i = 1, . . . , 6, j = 1, 2, 3 are parameters to be estimated, small letters
denote natural logarithms of the following variables: W , average wages, current
prices; P , consumer’s prices index (cost of living index); Z, labour productivity,
constant prices; U , rate of unemployment; K, non-wage costs, index; G, technical
progress, proxy; t = 1, . . . , T . Additionally, it is assumed that ξp : IID(0, σp ),
ξw : IID(0, σw ), ξz : IID(0, σz ).
The first equation is the standard wage function (see Tobin, 1995). It may be
also derived from the analysis of the compensation system in Poland and other
institutional solutions (see Welfe, 1991). A very similar wage function structure
may result from the acceptance of the standard bargaining model of wages and
prices (see Nickell, 1984; Layard et al., 1991). However, usually the real rather than
nominal wages are explained which means that unit long-run wage elasticity with
respect to prices is assumed. The Polish experience of transition period suggests
that this parameter should be estimated not imposed (see results in Welfe, 1996).
The second equation originates from the cost-push inflation theory and is equiv-
alent to the hypothesis that prices are influenced by the output costs increased by
 211

constant mark-up (see classic work of Tobin, 1972). Furthermore, this function may
be treated as the reduced form of the system of price equations for production sector
in input–output approach. Since in this equation the import prices were replaced
by non-wage costs, it allows for varying in time of the share of the import-output
ratio which is the case in Poland.
Finally the labour productivity is a function of capital–labour ratio, technical
progress and intensity of work, which is stimulated by increases of compensations
for work (wages). Because of a great bargaining power of the trade unions in
Poland the effect of money illusion did not play an important role, and therefore
real not nominal wages should be used in this function. The appropriate data for
technical progress does not exist. Therefore the trend variable was used as a proxy.
Since linear trend proved to be inappropriate, in a series of experiments logistic
trend with seasonality was chosen. As a result the estimate of the parameter γ13
can be biased and expresses partly also the effect of technical progress.

5. Sample data: Order of integration

The data comes from the quarterly data bank WK (documentation in: Kelm and
Sabanty, 1999) and covers the period from 1992.2 to 1999.2; year 1996 was as-
sumed as the base period.
The variable W has been defined as average nominal wages in production sector
of the economy. Prices, P are represented by the consumer’s price deflator. The
labour productivity, Z is the ratio of non-agricultural gross domestic product (in
constant prices) to employment in production sector of the economy. Non-wage
costs, K (in index terms) include intermediate costs, costs of imported materials
and other input costs (interest payments inter alia).
The variability of the time series used in the model is different, however, they
exhibit increasing long–run trend with short-run variations (see Fig. 2 and Table 1).
Significantly different from this pattern is the unemployment rate. Its behaviour is
mostly due to the changes of legal regulations which define who could register
as unemployed. Rapid decline of the unemployment rate in the second half of the
sample was particularly the consequence of the rules modifications. Furthermore,
the preliminary empirical results showed that the long-run elasticity of wages with
respect to unemployment was close to zero and statistically insignificant (see Welfe
and Majsterek, 2000). Therefore we excluded the unemployment rate from the
system.
The variability of most of the series seems to be smaller in recent years, and
the sample can be treated as rather homogeneous, although non-wages costs are
characterised by relatively greater variance than others.
The results presented in Table 2 prove that all variables are I(1), except for la-
bour productivity which is trend stationary. Therefore it is reasonable to postulate,
that some of them may cointegrate.
212
Table I. Descriptive statistics. The sample is respectively:
1992.2–1999.2 and 1992.3–1999.2.

Statistics Variable
w p z k g

Mean 6.626 −0.214 2.274 −0.146 0.021

Standard
deviation 0.511 0.427 0.128 0.322 0.011
Correlation coefficients
w 1 – – – –
p 0.996 1 – – –
z 0.926 0.903 1 – –
k 0.993 0.997 0.900 1 –
g 0.675 0.613 0.879 0.608 1

w p z k
Mean 0.056 0.046 0.015 0.035
Standard
deviation 0.064 0.026 0.093 0.029
Correlation coefficients
w 1 – – –
p 0.282 1 – –
z 0.877 -0.132 1 –
k −0.347 0.419 −0.559 1

6. Structuralisation of the model

The Johansen (1988) procedure was used to determine the cointegrating rank (see
Table 3); asymptotic and small sample tests procedures were applied.
In the first step it was assumed that technical progress is exogenous. The small
sample test identified two long-run independent relationships while the asymptotic
— three of them. It should be taken into account, however, that the results of the
small sample test tend to underestimate the number of cointegrating vectors on the
contrary to the large sample test results which usually suggests too many of them
(see analysis of Monte Carlo study reported by Greenslade at al., 1999). On the
other hand Johansen (1988) argues that consequences of overestimation of the coin-
tegration rank are less serious than underestimation. Also Doornik (1998) suggests
that it is better not to adjust for small sample. Hence, in the next steps we performed
the exogeneity test under assumption that three independent cointegration vectors
are present in the system.
The results of Wald test lead to the conclusion that all variables in the system are
endogenous (technical progress was assumed exogenous in all experiments). This
 213

Figure 2. Variables in the system: sample, 1992.2–1999.2.

Table II. Integration test

Variable Diagnostic statistics Conclusion

DF

w −1.972 I(1)
p −1.549 I(1)
z −8.165 I(0)
k −1.586 I(1)
−12.526 –
−4.546 –
−6.910 –
Note: Critical values for is −3.59 (critical val-
ues from Banerjee et al., 1993, p. 103). Both DF
and ADF test have been used for the deterministic
trend augmented version: DF, yt = α0 + (α1 −
1)yt −1 + α2 t + +t ; ADF, yt = α̃0 + (α̃1 −
1)yt −1 + α̃2 t + α̃3 yt −1 + +̃t .
We test: H0 : yt ∼ I (1) (α1 − 1 = 0); against the
alternative: H1 : yt ∼ I (0) (α1 − 1 < 0).
214

Table III. Test of cointegrating rank

Variables in the Asymptotic test statistics Small sample test

system statistics
r =0 r =1 r =2 r=3 r =0 r =1 r =2
S=2

w, p, z, k, g1 710.5 81.75 35.95 13.51 473.7 54.5 23.96

w, p, z, k, g2 1584 779.1 47.06 17.91 1056 519.4 31.38

S=1

w, p, z, k, g1 758.7 89.52 38.73 14.75 640.1 75.54 32.68

w, p, z, k, g2 1679 819.1 41.22 17.73 1400 691.1 34.78

Critical value 76.07 53.11 34.91 19.96 76.07 53.11 34.91

Note: 1 g is assumed exogeneous; 2 k and g are assumed exogeneous.

We test: H0 : r = k against the alternative: H1 : r > k. The rejection region is

right-sided.

Table IV. Exogeneity test

Variable R = 3, g is assumed R = 3, k and g are

exogeneous assumed exogeneous

S=2

w 162.8 38.47
p 57.06 33.49
z 322.4 112.1
k 12.78 0
g 0 0

S=1

w 314.2 47.24
p 58.91 22.59
z 643.0 297.3
k 18.17 0
g 0 0

Note: Critical value for α = 0.05 is χ32 = 7.815.

 215
Table V. Lag structure in VEqCM model

Dependent t statistics
variable wt −1 pt −1 zt −1 kt −1

wt −0.519 0.476 0.520 1.528

pt −0.396 0.244 0.621 −0.029
zt −0.293 −0.758 −0.171 0.554

is contradictory both to the number of identified cointegrating vectors (R=3) and

to the economic knowledge which suggests that non-wage costs shall be treated
as weakly exogenous in this system. Therefore, we additionally assumed exo-
geneity of non-wage costs and repeated steps (i)–(ii) under this assumption. The
results of cointegration rank test (see Table 3) suggest the existence of two (small
sample procedure) or three cointegrating vectors (asymptotic test). The Wald (see
Table 4) statistics clearly justify treating wages, prices and labour productivity as
endogenous in our system.
In the next step the order of lag was tested. In that case one can use standard
t statistic since all variables in the VECM are stationary. If estimates of gammas
are close to zero, order of lag may be reduced and steps (i)–(iii) should be repeated
for smaller S. Due to the limited sample the maximum of two lags was used in the
model. The results (see Table 5) allow for the reduction to one lag only.
Finally, for one lag, under the assumption that technical progress and non-
wages costs are exogenous three independent cointegration relationships and three
endogenous variables: wages, prices and labour productivity were identified. This
is fully congruent with the economic theory and initial assumptions.
The unrestricted system corresponding to (6) can be written as
w = γ01 + γ21 p + γ31z + γ41 k + γ51 g (8a)

p = γ02 + γ12 w + γ32z + γ42 k = γ52 g (8b)

z = γ03 + γ13 w + γ23 p + γ43 k + γ53 g (8c)

On the basis of economic theory we hypothesise that the following restrictions
hold:

in (7a) k and g are excluded, γ41 = γ51 = 0;

in (7b) prices satisfy homogeneity condition, γ12 + γ42 = 1, g is excluded;
in (7c) k is excluded, γ43 = 0; and γ13 = −γ23 .

The identification of the model requires at least nine restrictions: six are given
above, remaining three are the normalisation ones. To ensure the testability of
216

restrictions we added labour share constraint (γ12 = −γ32 ), which reflects the
assumption that only wage increase which is not justified by labour productivity
rise can accelerate inflation. Additionally, the value of the parameter γ53 was set on
level obtained from the separate study on technical progress, γ53 = 0.98.
The preliminary estimates were not acceptable: the elasticity of prices with
respect to non-wage costs was clearly underestimated while the elasticity with
respect to labour productivity – overestimated. Therefore we modified the homo-
geneity condition as follows

γ12 + γ42 = a where 1 ≤ a ≤ 1.2

which now allows the consumer price index to increase faster than the production
costs. It is important since the variable does not include the mark-up. Also the
influence of value added tax changes which took place during the period covered
by the sample can be reflected in this way.
The increase of labour productivity is the result of both labour intensity and
technical progress increase. The latter is usually followed by the change of the
quality of products which gives the producers the reason to rise the prices. Thus
the labour productivity increase can only partly contribute to inflation decline. This
is reflected by the modified labour share restriction

bγ12 = −γ32 where 0.5 ≤ b ≤ 1.

Finally, the long-run structural model can be written as follows

w = γ01 + γ21 p + γ31z (9a)

p = γ02 + γ12 (w − bz) + (a − γ12 )k (9b)

z = γ03 + γ13 (w − p) + 0.98g (9c)

The restrictions were not rejected by the data at standard significance level α =
0.05 since the value of the LR statistics is 4.380 (the critical value for 2 degrees of
freedom is 5.991).

7. Empirical results
The estimation results are presented in Table 6.1 All long-run estimates are eco-
nomically interpretable and the impact of all variables is statistically significant.
The price elasticity of wages is close to unity (1.022) which is usually expected
in the long-run. It confirms the NAIRU hypothesis and proves rather strong bar-
gaining position of the labour unions. The increase of real wages is then determined
1 Calculations have been performed by TSP and REG-X packages.
 217
Table VI. The estimates of the long-run structural parameters. Quarterly data, sample
1992.2–1999.2; the estimation by FIML

Dependent Variables
variable Const, p z w w-p k g

w 5.287 1.022 0.684 – – – –

(65.842) (302.726) (19.271)
p −3.287 – −0.437 0.624 – 0.476 –
(−13.926) (13.651)
z −6.204 – – – 1.236 – 0.98
(−15.560) (21.115)

by labour productivity increase. The estimate of the elasticity of wages with respect
to labour productivity rose from 0.4 obtained in the previous study (see Welfe and
Majsterek, 2000) to 0.684. This may allow for the conclusion that the role of the
market increased although the pressures towards full wage compensation of the
inflation (measured by γ21 ) are still strong.
The values for a and b (a = 1.1 and b = 0.7) were found in a series of
experiments. It should be mentioned, however, that the estimates of the structural
parameters were fairly stable and did not vary too much along with a and b changes
(within assumed ranges). The value of a = 1.1 means that indeed, prices tend to
increase faster than production costs. On the other hand value of b = 0.7 lower
than one reflects the fact that part of labour productivity rise can be attributed to the
change of the products quality which exerts pressure towards price increase. The
wage elasticity of prices is 0.624 and implies (through the modified homogeneity
condition) 0.476 elasticity of prices with respect to non-wages costs. It is possible
that in the previous studies due to classical homogeneity condition (γ12 + γ42 = 1)
the role of the non-wage costs was underestimated (0.25). The elasticity of prices
with respect to labour productivity equals −0.437 and seems to be economically
acceptable.
Elasticity of labour productivity with respect to real wages is rather high (1.236)
and confirms the thesis about lack of money illusion. As it was expected, the
increase of real wages gives strong incentives for labour productivity growth.

8. Conclusions
The empirical results allow for the following conclusions. Firstly, time series rep-
resenting prices (cost living index), average wages, non-wage unit costs are I(1).
Therefore the application of cointegration approach is necessary. Furthermore one
lag in the VECM system and three cointegrating vectors were identified among
these variables.
218

Secondly, introduction of the theoretical, economically acceptable restrictions

made it possible to arrive at a SVECM. In case of the system of five variables a set
of overidentifying restrictions was found what allowed for testing.
Thirdly, the sample of 29 observations is still too short to include more lags
and to obtain the estimates of the short-run effects. Limited sample was probably
the reason for the failure of the weak exogeneity test in case of non-wage costs.
Nevertheless, it seems that the transition period yields sufficiently rich statist-
ical data to verify empirically complex economic hypotheses concerning long-run
relationships between main economic macro-variables.

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