Structural reforms and fiscal adjustments: policy options for the euro area

This paper analyses the effects of structural reform and fiscal consolidation policies in the Euro Area using a stylized new-Keynesian model. A number of issues are focused upon: (i) the modelling and effects of fiscal consolidation and structural reforms, and (ii) evaluation of alternative reform and consolidation scenarios, including their joint implementation.     

Wealth effects on money demand in the euro area

We investigate the determinants of money demand (M3) in the euro area, considering that this variable remains an important co-determinant of monetary policy making by the European Central Bank. Regressing the real stock of M3 on real GDP, interest rates and wealth variables (real housing and stock prices) within an error-correction framework provides evidence of positive wealth effects on money demand in the long run. Correcting for this wealth effect, money demand in the euro area has grown almost exactly in line with the official reference value of 4 1/2% per annum. This article builds on research that was conducted in preparation of the annual OECD Economic Survey of the euro area and reported in Boone et al. (2004). The authors thank their colleagues in the Economics Department and the European Central Bank and two anonymous referees for their valuable comments. The authors assume full responsibility for any remaining errors and omissions. The opinions expressed in this article do not necessarily represent those of the OECD or its member countries     

QUEST III: An estimated open-economy DSGE model of the euro area with fiscal and monetary policy

This paper develops a DSGE model for an open economy and estimates it on euro area data using Bayesian estimation techniques. The model features nominal and real frictions, as well as financial frictions in the form of liquidity-constrained households. The model incorporates active monetary and fiscal policy rules (for government consumption, investment, transfers and wage taxes) and can be used to analyse the effectiveness of stabilisation policies. To capture the unit root character of macroeconomic time series we allow for a stochastic trend in TFP, but instead of filtering data prior to estimation, we estimate the model in growth rates and stationary nominal ratios.     

Growth accounting for the euro area

This article is concerned with the estimation of euro area potential output growth and its decomposition according to the sources of growth. The growth accounting exercise is based on a multivariate structural time series model which combines the decomposition of total output according to the production function approach with price and wage equations that embody Phillips-type relationships linking inflation and nominal wage dynamics to the output gap and cyclical unemployment, respectively. Assuming a Cobb?CDouglas technology with constant returns to scale, potential output results from the combination of the trend levels of total factor productivity (TFP) and factor inputs, capital and labour (hours worked), which is decomposed into labour intensity (average hours worked), the employment rate, the participation rate and population of working age. The nominal variables (prices and wages) play an essential role in defining the trend levels of the components of potential output, as the latter should pose no inflationary pressures on prices and wages. The structural model is further extended to allow for the estimation of potential output growth and the decomposition according to the sources of growth at different horizons (long run, medium run and short run); in particular, we propose and evaluate a model-based approach to the extraction of the low-pass component of potential output growth at different cut-off frequencies. The approach has two important advantages: the signal extraction filters have an automatic adaptation property at the boundaries of the sample period, so that the real-time estimates do not suffer from what is often referred to as the ??end-of-sample bias??. Secondly, it is possible to assess the uncertainty of potential output growth estimates with different degrees of smoothness.     

Estimating potential output and the output gap for the euro area: a model-based production function approach

This paper provides an analysis of multivariate unobserved components models for the estimation of potential output and the output gap in the euro area. Bivariate models of output and inflation and multivariate model-based implementations of the production function approach are considered; according to the latter potential output is derived from the permanent components of the factors of production consistent with stable inflation, whereas the output gap results from the combination of the transitory components. This approach allows to measure the contribution of the various factors of production to potential output growth, and to assess the reliability of the output gap estimates. Various alternative statistical specifications for the separation of trend and cycle are considered entertaining different economic hypotheses. The paper also provides an assessment of the reliability of the alternative output gap estimates and analyses their predictive validity by means of a rolling forecast exercise that provides an evaluation of the capability to forecast future inflation. A preliminary version of this paper appeared as EUI working paper ECO2002/09 and was presented at the European Central Bank, the European University Institute, the Growth and Business Cycles in Theory and Practice conference, Manchester UK, 20–21 June 2002, the Common Features in Rio conference, Rio de Janeiro, 29–31 July 2002. We thank the participants, Michael Artis, Gerard Korteweg, Geoff Kenny, Neale Kennedy, Manuel da Mota Freitas Martins, Gerard Ruenstler, and three anonymous Referees for useful discussions and valuable comments. The paper was largely written while the first author was acting as consultant for the ECB. The views expressed in it do not necessarily reflect those of the ECB. All correspondence to Alberto Musso.     

Non-linearities in euro area inflation persistence

This paper investigates the nature of inflation dynamics with a special focus on inflation persistence. Using data from euro area member-states we estimate dynamic non-linear panel models addressing in detail econometric issues concerning unobserved heterogeneity, genuine state dependence, and the initial conditions problem. After controlling for observed and unobserved heterogeneity, our results suggest that the degree of inflation persistence is genuine and varies depending on whether the inflation rate is too high, within the range of ECB's target of price stability, too low or negative. This implies that policies to stabilize inflation in the short run will have longer-run effects.     

Inflation and inflation uncertainty in the euro area

This article estimates a time-varying AR-GARCH model of inflation producing measures of inflation uncertainty for the euro area, and investigates their linkages in a VAR framework, also allowing for the possible impact of the policy regime change associated with the start of EMU in 1999. The main findings are as follows. Steady-state inflation and inflation uncertainty have declined steadily since the inception of EMU, whilst short-run uncertainty has stabilised. A sequential dummy procedure provides further evidence of a structural break coinciding with the introduction of the euro and resulting in lower long-run uncertainty. It also appears that the direction of causality has been reversed, and that in the euro period the Friedman-Ball link is empirically supported, consistently with the idea that the ECB can achieve lower inflation uncertainty by lowering the inflation rate.     

The private sector's perception of fiscal actions

This study attempts to investigate the household's perception of fiscal actions by testing the ultrarationality hypothesis advanced by David and Scadding (1974). A transcendental logarithmic utility function was used to present the house hold's choice. Demand equations for private and public goods were derived directly from utility maximization and were estimated simultaneously. Empirical findings offered no support for the view that households perceive government activities and adjust their behavior accordingly.     

Macroeconomic and financial effects of oil price shocks: Evidence for the euro area

The paper investigates the macroeconomic and financial effects of oil price shocks for the euro area, with a special focus on post-2009 oil price dynamics and the recent slump. The analysis is carried out episode by episode, by means of a large-scale time-varying parameter model. We find that recessionary effects are triggered by oil price hikes and, in some cases, also by oil price slumps. In this respect, the post-2009 run-up likely contributed to sluggish growth, while uncertainty and real interest rate effects are the potential channels through which the 2014 slump has depressed aggregate demand and worsened financial conditions. Also in light of the zero interest rate policy carried out by the ECB, in so far as the Quantitative Easing policy failed to generate inflationary expectations, a more expansionary fiscal policy might be required to counteract the deflationary and recessionary threat within the expected environment of soft oil prices.     

Differences in exchange rate pass-through in the euro area

This paper focuses on the pass-through of exchange rate changes into the prices of imports made by euro area countries originating outside the area. Using data on import unit values for 13 different product categories for each country, we estimate industry-specific rates of pass-through across and within countries for all euro members. In the short-run, pass-through rates differ across industries and countries and are less than one. In the long-run neither full pass-through nor equality of pass-through rates across industries and countries can be rejected. Differences exist across euro area countries in the degree that a common exchange rate movement gets transmitted into consumer prices and costs of production indices. Most of these differences in transmission rates are due to the distinct degree of openness of each country to non-euro area imports rather than to the heterogeneity in the structure of imports.     

On the sources of macroeconomic stability in the euro area

In the mid-1990s the euro area experienced a change in macroeconomic volatility. Around the same time, at business cycle frequencies the correlation between inflation and money growth changed markedly, turning from positive to negative. Distinguishing the periods pre- and post-1994, we estimate a dynamic stochastic general equilibrium model with money for the euro area. The model accounts for the salient facts. We then perform several counterfactual exercises to assess the drivers of these phenomena. The moderation of real variables was essentially due to relatively smaller shocks to investment, wage markups and preferences. The apparent lack of evidence for the quantity theory of money in the short run and the changes in the volatility of nominal variables resulted primarily from a more anti-inflationary and gradual monetary policy.     

New technologies and productivity growth in the euro area

This paper provides an overview of the available evidence on the importance of information and communication technologies (ICT) for developments in average labour productivity (ALP) growth in the euro area. The contribution of ICT to ALP growth is found to have increased both in terms of production and investment over the 1990s (up to 2001). However, there is no evidence of significant positive spillover effects from the use of ICT on ALP growth. This implies that there is no reason to believe that potential output growth in the euro area has increased significantly in recent years on account of new technologies. Comparing developments in the euro area and the United States, it appears, however, that ICT capital cannot account for much of the difference in ALP developments over the 1990s. This suggests that cyclical developments and, in particular, the structure of the economy are more important for explaining the difference in performance.First version received: March 2002/Final version received: May 2003We thank Bart van Ark, Neale Kennedy, Gerard Korteweg, Ad van Riet, Marcel Timmer, two anonymous referees and participants at the 17th Congress of the European Economic Association, Venice August 2002 for their comments. All errors and omissions remain ours, of course. We thank Erikos Velissaratos for his help in acquiring data on investment in ICT and Colin Webb for providing us with the OECD STAN database. This paper represents the views of the authors and does not necessarily reflect the views of the European Central Bank, the European Commission or their staff.     

Money velocity and asset prices in the euro area

Monetary growth in the euro area has exceeded its target since several years. At the same time, the money demand function seems to be increasingly unstable if more recent data are used. If the link between money balances and the macroeconomy is fragile, the rationale of monetary aggregates in the ECB strategy has to be doubted. In fact, a rise in the income elasticity after 2001 can be observed, and may reflect the exclusion of real and financial wealth in conventional specifications of money demand. This presumption is explored by means of a cointegration analysis. To separate income from wealth effects, the specification in terms of money velocity is preferred. Evidence for the presence of wealth in the long run relationship is provided. In particular, both stock and house prices have exerted a negative impact on velocity after 2001 and lead to almost identical equilibrium errors. The extended error correction model is stable over the entire sample period and survive a battery of specification tests.

Inflation (mis)perceptions in the euro area

There has been a growing interest on inflation perceptions in the euro area, in particular, following the euro cash changeover. It has been pointed out that a gap emerged between observed and perceived inflation since the introduction of the euro notes and coins. Such a statement relies on the fact that inflation perceptions, measured by the well-known balance statistic from the European Commission’s consumer survey, hiked after January 2002 and remained high thereafter, as opposed to the observed inflation, which has remained fairly stable. In this paper, we discuss the measurement of inflation perceptions, by comparing the balance statistic with a refined alternative measure, which is computed using the probability method. We argue that the balance statistic should be used carefully, as it can lead to misleading conclusions. In fact, we find no evidence, both for euro area and individual countries, of the breakdown in the relationship between observed and perceived inflation, as measured by the proposed alternative measure, at the time of the euro cash changeover.     

Deleveraging,deflation and depreciation in the euro area

During the post-crisis period, economic performance has been highly heterogenous across the euro area. While some economies rebounded quickly after the 2009 output collapse, others are undergoing a protracted further decline as part of an extensive deleveraging process. At the same time, inflation has been subdued throughout the whole of the euro area and intra-euro-area exchange rates have hardly moved. We interpret these facts through the lens of a two-country model of a currency union. We find that deleveraging in one country generates deflationary spillovers which cannot be contained by monetary policy, as it becomes constrained by the zero lower bound. As a result, the real exchange rate response becomes muted, and the output collapse—concentrated in the deleveraging economies.     

The general equilibrium effects of fiscal policy: Estimates for the Euro area

This paper describes a dynamic stochastic general equilibrium model featuring a fraction of non-Ricardian agents in order to estimate the effects of fiscal policy in the Euro area. The model takes into account distortionary taxation on labor and capital income and on consumption, while expenditures are broken down into purchases of goods and services, compensation of public employees and transfers to households. A newly computed quarterly data set of fiscal variables is used. Our results point to the prevalence of mild Keynesian effects of public expenditures. In particular, although innovations in fiscal policy variables tend to be rather persistent, government purchases of goods and services and compensations for public employees have small and short-lived expansionary effects on private consumption, while innovations in transfers to households show a slightly more sizeable and lasting effect. The effects are more significant on the revenue side: decreases in labor income and consumption tax rates have sizeable effects on consumption and output, while a reduction in capital income tax favors investment and output in the medium run. Finally our estimates suggest that fiscal policy variables contribute little to the cyclical variability of the main macro variables.     

Interest rate reaction functions for the euro area

Estimating interest rate reaction functions for the euro area is still hampered by the short time span since the conduct of a single monetary policy. This is why estimates of union-wide reaction functions are usually based on historical pre-EMU data. In this paper we circumvent the common use of aggregated data before 1999 by estimating interest rate reaction functions based on a panel including actual EMU Member States. We find that exploiting the cross-section dimension of a multi-country panel and accounting for cross-country heterogeneity in advance of the single monetary policy improves the ability of historical reaction functions to describe actual interest rate dynamics. We retrieve a panel reaction function which is employed for evaluating interest rate setting since 1999.     

Welfare effects of the euro cash changeover

Using merged data from the British Household Panel Survey (BHPS) and the German Socio-Economic Panel (SOEP), this paper applies a parametric difference-in-differences approach to assess the real effects of the introduction of the euro on subjective well-being. A complementary nonparametric approach is also used to analyze the impact of difficulties with the new currency on well-being. The results indicate a loss in well-being associated with the introduction of the new currency, with the predicted probability that a person is contented with his/her household income diminishing by 9.7 percentage points. We calculate a compensating income variation of approximately one-third. That is, an increase in post-government household income of more than 30% is needed to compensate for the clear decline in well-being. The reasons for the negative impact are threefold. First, perceived inflation overestimates the real increase in prices resulting in suboptimal consumption decisions. Second, money illusion causes a false assessment of the budget constraint. Third, individuals have to bear the costs from the conversion and the adjustment to the new currency. Moreover, it is thought that losses are higher for persons who have difficulties with the new currency. However, the impact of difficulties in using and converting the new currency is rather small, and the initial problems were overcome within one year of the introduction of euro cash.