Abstract
This compilation of summaries of Working Papers released during January-June 1995 is being issued as a part of the Working Paper series. It is designed to provide the reader with an overview of the research work performed by the staff during the period. Authors of Working Papers are normally staff members of the Fund or consultants, although on occasion outside authors may collaborate with a staff member in writing a paper. The views expressed in the Working Papers or their summaries are, however, those of the authors and should not necessarily be interpreted as representing the views of the Fund. Copies of individual Working Papers and information on subscriptions to the annual series of Working Papers may be obtained from IMF Publication Services, International Monetary Fund, 700 19th Street, Washington, D.C. 20431. Telephone: (202) 623-7430 Telefax: (202) 623-7201.
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.