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A SMALL ESTIMATED EURO AREA MODEL WITH RATIONAL EXPECTATIONS AND NOMINAL RIGIDITIES

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Abstract

The objective of this paper is to estimate a small model of the euro area to be used as a laboratory for  evaluating  the  performance  of  alternative  monetary  policy  strategies. We  start  with  the relationship between output and inflation and investigate the fit of the nominal wage contracting model due to Taylor (1980) and three different versions of the relative real wage contracting model
proposed by Buiter and Jewitt (1981) and estimated by Fuhrer and Moore (1995a) for the United
States. While Fuhrer and Moore reject the nominal contracting model and find strong evidence in
favor of the relative contracting model which induces a higher degree of inflation persistence, we
find  that  both  types  of  contracting  models  fit  euro  area  data  reasonably well. The  best  fitting
specification  is  a  version  of  the  relative  contracting  model,  but  one  that  is  theoretically  more
plausible than the one preferred by Fuhrer and Moore for U.S. data.
A drawback of the euro area estimation is that the data are averaged over the member economies,
which  experienced  different monetary  policy  regimes  prior  to  the  formation  of EMU. Whereas
Germany enjoyed stable inflation with fairly predictable monetary policy, countries such as Italy and
France  experienced  a  long-drawn  out  and  probably  imperfectly  anticipated  disinflation.  To investigate  the  validity  of  our  results, we  also  obtain  estimates  for  France,  Germany  and  Italy separately. We  find  that the  relative  contracting  model  does  quite  well  in  countries  which transitioned out of a high inflation regime such as France and Italy, while the nominal contracting model fits German data  better. Thus,  an  optimist may  conclude  that  the  independent European Central Bank will face a similar environment in the future as the Bundesbank did in Germany and pick the nominal contracting specification, while a pessimist, who suspects that stabilizing euro area inflation will require higher output losses, may want to pick the relative contracting specification. We  close  the  model  by  estimating  an  aggregate  demand  relationship  and  investigate  the consequences of the different wage contracting specifications for the output costs associated with stabilizing inflation, when interest rates are set according to Taylors rule.

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