Inflation models for the Euro area
In Section 8.3 we found that an inverted money demand function did not provide a sound basis for explaining inflation in the Euro area. Still, there may be a case for models of inflation that conceive of inflation primarily as a monetary phenomenon. In this section, we compare and evaluate four inflation models which have been used to analyse data for the Euro area. These include the P*-model, which relates the steady-state of the price level to the quantity theory of money, a hybrid New Keynesian Phillips curve model (NPCM) of inflation (see Chapter 7) and two reduced form inflation equations: one derived from the dynamic version of the Incomplete Competition Model (ICM) we developed in Chapters 5 and 6, and the other from the wage-price block of the AWM of the European Central Bank.
Many researchers addressing inflation in the Euro area have opted for approaches like the P*-model or the NPCM, which either amounts to modelling inflation as a single equation or as part of very small systems. By contrast, the price block of the AWM, as described in Fagan et al. (2001), is defined within a full-blown macroeconometric model for the Euro area, even though the equations for wage growth and inflation are estimated by single equation methods. Moreover, the AWM is providing the most commonly used data set for the Euro area, and hence it is an obvious benchmark and point of reference for the comparison.'
In the following we shall give an outline of the wage-price block of the AWM (Section 8.5.1), brief reminders of the ICM (Section 8.5.2) and the NPCM (Section 8.5.3) which are described elsewhere in this book and, finally, a more detailed presentation of the P*-model (Section 8.5.4).