Exchange Rate Movements and Inflation Performance: The Case of Italy

Exchange Rate Movements and Inflation Performance:
The Case of Italy by Robert Ford and Thomas Krueger

The currencies of several countries in Europe depreciated sharply in
the aftermath of the turmoil in the exchange rate mechanism (ERM) of the
European Monetary System (EMS) in September 1992. This episode raised fears
of increased inflationary pressures and a partial reversal of recent
progress toward price stability. In the event, however, inflation remained
at historically low levels and in several countries, like Italy, it even
continued to decline gradually.

This paper investigates the recent inflation performance of Italy in
the context of a four-equation econometric model that highlights the
relationships between traded goods prices, the exchange rate, labor market
structure, and the business cycle on the one hand, and domestic prices and
wages on the other hand. The long-run estimates, derived from cointegrating
relationships, are consistent with essentially full pass-through from
exchange rates and foreign prices to domestic prices and wages. At the same
time, dynamic estimates imply that inflation is significantly influenced by
the business cycle, as proxied by estimated output and labor market gaps,
and that there may be pricing-to-market behavior, which could attenuate
the short-term effect of the exchange rate depreciation on imported goods
prices in Italy.

Applied to the recent episode, these findings suggest that the pass-
through of the exchange rate depreciation to the domestic prices of traded
goods was broadly in line with historical experience, but that the business
cycle downturn more than offset this effect, resulting in the observed
inflation declines.

A key issue for policy is the effect on wage and price formation of the
significant changes recently made to labor market institutions in Italy,
particularly the abolition of wage indexation (scala mobile) and the
establishment of a new wage bargaining framework. There is as yet
insufficient experience with the new institutional arrangements to address
this issue econometrically. Nevertheless, some aspects of the model suggest
that a structural break may have occurred. In particular, the wage equation
substantially overpredicts wages in 1993.