The paper presents the results of empirical models of inflation dynamics in Ukraine over 1999 - 2008. Its objective is to shed light on the sources of inflation during this period, as there is widespread disagreement among policy makers and analysts about the concrete underlying reason(s). This disagreement is not surprising, however, since without a proper empirical assessment based on statistical analysis this issue cannot be solved fundamentally. This is turn implies that policy responses geared at fighting inflation might lack sound empirical justification and might therefore be not fully efficient or even wrong-directed. However, especially in the recent period of very high inflation - which is one of the macroeconomic imbalances which Ukraine currently faces - it seems absolutely necessary to respond quickly and with correctly targeted measures.
Our analysis demonstrates that it is in principle possible to empirically model the inflation process in Ukraine in a theory-consistent way, which further carries important implications for policy makers. Policies to constrain aggregate demand like a tightening of monetary policy are well founded in the established long-run relationship between money and prices in Ukraine. At the same time, the influence of fiscal policy is more difficult to detect empirically, and more restricted to a temporary influence. However, this does not imply that fiscal policy carries no responsibility for fighting inflation, but rather points at difficulties in correctly assessing its inflationary impact given limited data on fiscal coverage. The crucial impact of credible fiscal policy measures on inflation via expectations formation, which is out of the focus of our empirical analysis, is a key factor in dampening price pressure.
The strong influence of external factors like commodity prices and changes in the exchange rate on inflation can further be firmly established; a fact that does not come as a surprise in Ukraine's open economy context. The policy of limiting exchange rate changes by avoiding sharp and massive depreciations seems thus appropriate with regard to fighting inflation. Of course, such a strategy corresponds well to the concept of reliably restraining monetary and fiscal policy.
However, also supply-side explanations of inflation could clearly be established. These findings point to the necessity to supplement short-term demand management with long-term aggregate supply-side measures. Structural and institutional reforms to make supply more flexible are equally necessary to encourage response in quantities rather than prices when meeting strong demand pressures.
