Deficits, Money Growth and Inflation in Italy: 1875–1994

Abstract

In this paper, we examine econometrically the “fiscal dominance” model of the Monetary History of Italy proposed by Spinelli and Fratianni (1996). We test the proposition that monetary policy is endogenous to fiscal policy, and that such an endogeneity creates a specificity in the process generating Italian inflation. We perform our econometric tests by estimating a small structural linear econometric model, addressing carefully the issues of data‐congruency of the specification, non‐stationarity, cointegration, and credibility of the over‐identifying restrictions. Our econometric investigation is based on a sample of annual observations from 1875–1994 and exploits the structural break which occurred in 1975, when Baffi became Governor of the Bank of Italy and the lack of independence of the central bank was first perceived as a problem. Baffi started the slow evolution process leading to the independence of the central bank, which was institutionally ratified by his successor Ciampi, when, in 1981, the Bank of Italy interrupted his commitment to buy all the government bonds left unsold in the public tenders (the “divorce”). Our empirical analysis over the sample 1875–1975 confirms the existence of a link between government deficit and money growth, and of a long‐run relationship between the quantity of money and the price level; the evidence also stresses the relevance of supply side factors in the determination of inflation. When the model estimated for the sample 1875–1975 is applied to the period 1975–1994, a clear structural break in the relation between government deficits and money growth emerges. (J.E.L.: E5, E6).