A Small Estimated Euro-Area Model with Rational Expectations and Nominal Rigidities

With the formation of European Monetary Union (EMU) in 1999, the eleven countries that adopted the Euro began to conduct a single monetary policy oriented towards unionwide objectives. The objective of this paper is to construct a small model of the Euro area, which may serve as a laboratory for evaluating the performance of alternative monetary policy strategies for the Euro area in the vein of recent studies for the United States. In estimating this model, we start with the relationship between output and inflation and investigate the nominal wage contracting model due to Taylor (1980) as well as three different versions of the relative real wage contracting model first proposed by Buiter and Jewitt (1981) and investigated empirically with U.S. data by Fuhrer and Moore (1995a). Contrary to Fuhrer and Moore, who reject the nominal contracting model and prefer a version of the relative contracting model which induces a higher degree of inflation persistence, we find that both types of contracting models fit the data for the Euro area. The best fitting specification, however, is a version of the relative contracting model, which is theoretically more plausible than the simplified version preferred by Fuhrer and Moore. These findings are relevant to the continuing debate on stickyinflation versus sticky-price models (for example Roberts (1997), Sbordone (1999), Gali and Gertler (1999) and Taylor (1999)) and may have important implications for the short-run inflation-output tradeoff faced by the Eurosystem. A drawback of the Euro area estimation is that the data are averages of the member economies, which experienced different monetary policy regimes prior to the formation of EMU. While Germany enjoyed stable inflation with fairly predictable monetary policy, countries such as France and Italy experienced a long-drawn out and probably imperfectly anticipated disinflation. To investigate the validity of our results, we also estimate the contracting models for France, Germany and Italy separately. We find that the relative contracting model dominates 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. A robust monetary policy strategy, however, should perform reasonably well in both cases. We close the model by imposing a term-structure relationship and estimating an aggregate demand relationship. We then evaluate the performance of Taylor’s rule as an example.