Euro area inflation: long-run determinants and short-run dynamics

Abstract

This study adopts the long-run structural VAR approach to analyse the determinants of inflation in the Euro Area economy over the period 1985:1–2003:2. Theoretical relationships link inflation to markup and output gap, respectively. The short-run dynamic properties of inflation are investigated using a structural VECM. Inflation is explained by a mixture of supply- and demand-side factors, both in the long- and the short-run. The simulation exercise indicates that a positive shock to inflation could have a favourable re-distributional income effect on wage earners and non-detrimental consequences either on productivity and on competitiveness. Finally, the model produces satisfactory out-of-sample forecasts.

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