A small estimated euro area model with rational expectations and nominal rigidities

Abstract

We estimate a small model of the euro area to be used for evaluating alternative monetary policy strategies. Starting with the relationship between output and inflation we compare the fit of the nominal wage contracting model due to Taylor (J. Political Econom. 88 (1980) 1) and the relative real wage contracting model proposed by Buiter and Jewitt (The Manchester School 49 (1981) 211; reprinted in Buiter (Ed.), Macroeconomic Theory and Stabilization Policy, Manchester University Press, Manchester, 1989) and estimated with U.S. data by Fuhrer and Moore (Quart. J. Econom. 110 (1995) 127). While Fuhrer and Moore reject nominal contracts in favor of relative contracts, which induce more inflation persistence, we find that both specifications fit euro area data reasonably well. When considering France, Germany and Italy separately, however, we find that nominal contracts fit German data better, while the relative contracting model does well with respect to formerly high inflation countries such as France and Italy. We close the model by estimating an aggregate demand relationship and investigate the implications of nominal versus relative contracts for the inflation-output variability tradeoff when monetary policy follows Taylor's rule.