Economics of Planning 30: 205–220, 1997. 205 c 1997 Kluwer Academic Publishers. Printed in the Netherlands. The Price-Wage Mechanism in Poland: An Endogenous Switching Model JACEK OSIEWALSKI 1 and ALEKSANDER WELFE 2 1 Department of Econometrics, Academy of Economics, ul. Rakowicka 27, 31-510 Krak´ ow, Poland 2 Institute of Econometrics and Statistics, Department of Forecasts and Simulation Analyses, University of L ´ od´ z, ul. Rewolucji 1905 r. 41, 90-214 L´ od´ z, Poland Abstract. This paper proposes a two-equation price-wage model that enables to test whether the inflationary pressure on wage rate is only present when the rate of inflation is greater than some threshold value. Since the likelihood function for this model is very nonstandard, we develop a small- sample Bayesian approach to estimate its parameters. Our empirical results for Poland, 1962-1993, give support to the hypothesis of the price- wage spiral with a positive threshold value of inflation. 1. Introduction Inflation seems to be one of the most carefully observed and studied economic phenomena. The literature devoted almost exclusively to inflation consists of a huge number of publications (cf. for example items cited by P.A. Rowlatt, 1992 and W. Frish, 1993). Surprisingly, inflation in the East European countries was treated by economists as a marginal problem for a long time. The reason was political: the possibility of existence of inflation in socialist countries was questioned. The official propaganda claimed that a stable growth could be achieved without processes characteristic of the capitalist system among which unemployment and the increase in costs of living were the most unwanted. On the other hand, in Poland, during the decade of the ’60s, the officially reported annual growth rates of consumer goods’ prices were below 2%, which almost justified this thesis. The excess demand manifesting in some markets during these years (mostly for textiles, clothes and durables) was called “a periodical difficulty”. The ’70s brought a considerable increase in inflation in Poland and since then Polish economists have been developing their interest in studying inflation process- es. However, many of them believed that the government fully controlled wages in the socialized sector, which constituted more than 95% of the Polish economy, and also prices in the socialized sector supplying over 90% of the goods purchased by consumers. Thus inflation was typically explained as the result of inefficiency in the planning process. It is important, however, to notice that the system of price and wage setting at the firm level was evolving over time. In the ’60s and espe- cially in the ’70s the increase of wages was limited by the rate of growth of labour productivity (the elasticity superimposed by the central bodies was around 0.6). In