omestic an S rices in an Open Economy: The Case of Denmark Katarina Juselius, zyxwvutsrqponmlkjihgfedcbaZYXWVUTSRQPONMLKJIHGFEDC Ukversim of Copenhgen c Domestic price determination in Denmark is investigated using three kinds of ma- croeconomic explanations: ( 1) internal labor market theories describing the relation between price and wage inflation. (2) pure monetarist theories describing the effect of excess money on the inflation rate. and (3) external theories describing the foreign transmission effects on a small open economy. The empirical analysis makes use of the multivariate cointegration model, which is based on the joint analysis of long- and short-run behavior. The deviations from derived underlying steady states in each sector were found to be the main determinants of the inflation rate. .4mong these, the domestic effects were small compared to the foreign effects. The empirical results strongly favored a backward-looking behavioral model in terms of structurally stable parameters as opposed to a forward-looking expectations model. The results starld up as quite strong evidence against the Lucas critique. 1. INTRODUCTION The empirical purpose of this article is to investigate domestic znd in- ternational transmission effects on prices in Denmark. It illustrates pos- sible causes of inflation in a smali open economy and the way inflation i5. affected by the increasing economic integration within the European Economic Community. The basic idea is that consumer price inflation can be associated with domestic wage inflation, that is, nominal wages above the underlying steady-state level; with monetary inflation, that is, excess money; and with imported inflation. To derive observational var- iables for these three theoretical concepts, we will use some recent econ- Address t.t)rre.~pt~lldt’l!rY to Projkwr Kafurina zyxwvutsrqponmlkjihgfedcbaZYXWVUTSRQPON Juw fius. Institute of Etwnorrrit~s, Unir*ersirF t$ Ctywnhagen. Srudiesrrtiede, 6, DK-1455. Copenhagen K. Dtvvmu-k. This article was prepared as part of a Nordic research project with financial suppl~rt from the Nordic Council for Cooperation in the Social Sciences. It was presented at the EC’ conference in Amsterdam. December 1990. at the Nordic workshop on multivariate cointegration in AI, Norway. 1990. at the Fconomics Departmeat. University of Lund. and at the workshop ‘)n cointegration in aerlin. 1991. Comments an:4 suggestions from partic:panrs in these meetings are gratefully acknowledged. A special thanks for valuable comments and useful suggestions goes to the editor and to Seren Johansen. Received March 1991; final draft accepted August 1991. Journtd of Policy Modeling 14(4):40 l-328 ( 1992) 0 Society for Policy Modeling, 1992 401 0161~8938/92/$5.00