Abstract—According to the interaction of inflation and unemployment, expectation of the rate of inflation in Croatia is estimated. The interaction between inflation and unemployment is shown by model based on three first-order differential i.e. difference equations: Phillips relation, adaptive expectations equation and monetary-policy equation. The resulting equation is second order differential i.e. difference equation which describes the time path of inflation. The data of the rate of inflation and the rate of unemployment are used for parameters estimation. On the basis of the estimated time paths, the stability and convergence analysis is done for the rate of inflation. Keywords—Differencing, inflation, time path, unemployment. I. INTRODUCTION HE main aim of the paper is to estimate the expectation of the rate of inflation in Croatia using mathematical model based on the system of differential i.e. difference equations. The paper is organized in five sections. After this introductory section, in the second section the mathematical model is presented. The basic framework is taken from [2] where the resulting equations are achieved according to the three differential/difference equations describing inflation- unemployment interaction. In this paper, in discrete form of the model, instead of monetary policy equation based on the rate of inflation from forward periods, the latter equation is based on the current rate of inflation. That implies new form of the resulting second order difference equation in the rate of inflation. The third section uses statistical-econometric methods for the parameters estimation from the previously derived model. All approximations are done using the monthly data of the rate of inflation and the rate of unemployment in Croatia in period from 1998. to 2008. The presented and used parameter results satisfy all appropriate tests, what is clearly exposed in this part of the paper. In the fourth section, the presented model with incorporated estimated parameters is Z. Aljinović is with the University of Split, Faculty of Economics, Matice hrvatske 31, Split 21000, Croatia (phone: +385-21-430-644; fax: +385-21- 430-701; e-mail: zdravka.aljinovic@ efst.hr). S. Pivac is with the University of Split, Faculty of Economics, Matice hrvatske 31, Split 21000, Croatia (phone: +385-21-430-645; fax: +385-21- 430-701; e-mail: spivac@ efst.hr). B. Šego is with the University of Zagreb, Faculty of Economics, Trg J. F. Kennedy 6, Zagreb 10000, Croatia (phone: +385-01-238-3323; e-mail: bsego@ efzg.hr). applied on Croatian economy. The convergent time path of the rate of inflation with a stationary intertemporal equilibrium is obtained. Finally, some concluding remarks are given. II. THE MODEL A. The Expectations-Augmented Phillips Relation The most widely used concept in analyzing the problem of inflation and unemployment is the Phillips relation which, in its original formulation, depicts an empirically based negative relation between the rate of growth of money wage and the rate of unemployment [3]: . ) U ( f ), U ( f w 0 < ′ = (1) where w denotes the rate of growth of money wage W ( W W w ′ = ) and U is the rate of unemployment. This relation can be adapted into a function that links the rate of inflation (instead of w) and the rate of unemployment. A positive w, reflecting growing money-wage cost, would carry inflationary implications, and that makes the rate of inflation, like w, a function of U. However, the inflationary pressure of a positive w can be offset by an increase in labor productivity T and the inflationary effect can materialize only to the extent that money wage grows faster than productivity. Thus, for the rate of inflation it can be written: , T w p − = (2) where P P p ′ = , P is the price level. By adopting the linear version of the function ) U ( f , an adapted Phillips relation follows [5]: . , , U T p 0 > − − = β α β α (3) More recently, economists have preferred to use the expectations-augmented version of the Phillips relation [5]: , h , h ) U ( f w 1 0 ≤ < + = π (4) where π denotes the expected rate of inflation. If an inflationary trend has been in effect long enough, people are An Expectation of the Rate of Inflation According to Inflation-Unemployment Interaction in Croatia Zdravka Aljinović, Snježana Pivac, and Boško Šego T World Academy of Science, Engineering and Technology International Journal of Economics and Management Engineering Vol:3, No:1, 2009 95 International Scholarly and Scientific Research & Innovation 3(1) 2009 ISNI:0000000091950263 Open Science Index, Economics and Management Engineering Vol:3, No:1, 2009 publications.waset.org/9789/pdf