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.
