No. 310 - Inflation and Monetary Policy in Italy: Some Recent Evidence

The empirical literature on the transmission of monetary policy to inflation in Italy has stressed the importance of the exchange rate and, to some extent, of the demand channel; recently, the roles of inflation expectations and the fiscal situation have been emphasized. This paper uses vector auto-regression to address the issue. The results suggest that inflation expectations do matter as determinants of inflation, along with the exchange rate and demand. Expectations on the sustainability of the public debt are found to have a significant effect on the exchange rate, but only a moderate effect on inflation, thus rejecting the assumption of "fiscal dominance". The VAR confirms that the two episodes of sharp exchange rate depreciation (in 1992 and 1995) made a major contribution to inflationary tensions, but also shows that demand shocks and the expectational climate played an important role.