The currencies of several countries in Europe depreciated sharply in the aftermath of the turmoil in the exchange rate mechanism (ERM) of the European Monetary System (EMS) in September 1992. This episode raised fears of increased inflationary pressures and a partial reversal of recent progress toward price stability. In the event, however, inflation remained at historically low levels and in several countries, like Italy, it even continued to decline gradually.
This paper investigates the recent inflation performance of Italy in the context of a four-equation econometric model that highlights the relationships between traded goods prices, the exchange rate, labor market structure, and the business cycle on the one hand, and domestic prices and wages on the other hand. The long-run estimates, derived from cointegrating relationships, are consistent with essentially full pass-through from exchange rates and foreign prices to domestic prices and wages. At the same time, dynamic estimates imply that inflation is significantly influenced by the business cycle, as proxied by estimated output and labor market gaps, and that there may be “pricing-to-raarket” behavior, which could attenuate the short-term effect of the exchange rate depreciation on imported goods prices in Italy.
Applied to the recent episode, these findings suggest that the pass-through of the exchange rate depreciation to the domestic prices of traded goods was broadly in line with historical experience, but that the business cycle downturn more than offset this effect, resulting in the observed inflation declines.
A key issue for policy is the effect on wage and price formation of the significant changes recently made to labor market institutions in Italy, particularly the abolition of wage indexation (scala mobile) and the establishment of a new wage bargaining framework. There is as yet insufficient experience with the new institutional arrangements to address this issue econometrically. Nevertheless, some aspects of the model suggest that a structural break may have occurred. In particular, the wage equation substantially overpredicts wages in 1993.