Project Abstract

Abstract
This research project aims to develop a small estimated euro area model that incorporates rational expectations and nominal rigidities. The model is designed to capture the key features of the euro area economy, such as the presence of nominal rigidities in prices and wages, as well as the role of expectations in shaping economic outcomes. By incorporating rational expectations, the model allows for a consistent and forward-looking framework, which is essential for analyzing the dynamics of the euro area economy. The model includes key sectors such as households, firms, and the government, each with its set of decision rules and constraints. Households are assumed to maximize utility subject to a budget constraint, taking into account the expected future path of prices and wages. Firms set prices and wages in a forward-looking manner, considering not only current economic conditions but also future expectations. The government plays a role through fiscal policy, influencing aggregate demand and potentially affecting the behavior of other sectors. The model is estimated using Bayesian techniques on euro area data, allowing for the identification of key parameters and structural relationships. By calibrating the model to match key macroeconomic variables such as output, inflation, and interest rates, it provides a framework for analyzing the transmission mechanisms of monetary policy and other economic shocks within the euro area. The incorporation of nominal rigidities and rational expectations allows for the analysis of how these factors interact to generate economic fluctuations and influence policy effectiveness. The small estimated euro area model serves as a valuable tool for policymakers and researchers in understanding the dynamics of the euro area economy. By providing a coherent framework that captures the key features of the economy, it can be used to analyze the effects of different policy interventions, forecast future economic conditions, and evaluate the impact of structural reforms. The model also allows for scenario analysis, enabling policymakers to assess the potential consequences of different shocks and policy responses. Overall, the small estimated euro area model with rational expectations and nominal rigidities offers a comprehensive and flexible framework for analyzing the dynamics of the euro area economy and evaluating the implications of different policy choices.

Project Overview

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.