Surprise! Euro Area Inflation Has Fallen

33 Pages Posted: 10 Mar 2015

Date Written: September 26, 2014

Abstract

Between 2013 and 2014, following the recession triggered by the sovereign debt crisis, euro-area inflation decreased sharply. Although a fall in the inflation rate was to be expected, given the severity of the recession, professional forecasters failed to anticipate it. A possible explanation for this forecast failure lies in a break in the cyclicality of inflation, which was unaccounted for in forecasting models. We probe this explanation in the context of a simple backward-looking Phillips curve and find that the sensitivity of inflation to the output gap has recently increased. We rationalize this result through a structural model, in which a steepening of the Phillips curve arises either from lower nominal rigidities (a decrease in the average duration of prices) or from fewer strategic complementarities in price-setting due to a reduction in the number of firms in the economy.

Keywords: inflation, Phillips curve, structural break, strategic complementarities

JEL Classification: E31, E37, C53

Suggested Citation

Riggi, Marianna and Venditti, Fabrizio, Surprise! Euro Area Inflation Has Fallen (September 26, 2014). Bank of Italy Occasional Paper No. 237, Available at SSRN: https://ssrn.com/abstract=2575673 or http://dx.doi.org/10.2139/ssrn.2575673

Marianna Riggi

Bank of Italy ( email )

Via Nazionale 91
00184 Roma
Italy

Fabrizio Venditti (Contact Author)

Bank of Italy ( email )

Via Nazionale 91
00184 Roma
Italy

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