In this paper we jointly estimate the natural unemployment and participation rates for Italy through a forward-looking Phillips curve informed by structural labour market flows and demographic trends. We then exploit our model to assess the effect on inflation of a sudden expansion in labour supply caused by a far-reaching and unexpected pension reform implemented in 2012.
We find that the estimated reaction of inflation to the participation gap (the difference between the actual and the natural participation rates) is twice as large as that to the unemployment gap (the difference between the actual and the natural unemployment rates). Moreover, we find that, while the pension reform did not affect the unemployment gap, it triggered an increase in the participation gap. Trends in activity thus explain in part why inflation has been so low in recent years.
