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Why is inflation so low in the euro area?

Antonio Conti (), Stefano Neri () and Andrea Nobili ()

No 1019, Temi di discussione (Economic working papers) from Bank of Italy, Economic Research and International Relations Area

Abstract: Inflation in the euro area has been falling steadily since early 2013 and at the end of 2014 turned negative. Part of the decline has been due to oil prices, but the weakness of aggregate demand has also played a significant role. This paper uses a VAR model to quantify the contribution of oil supply, aggregate demand and monetary policy shocks (identified by means of sign restrictions) on inflation in the euro area. The analysis suggests that in the last two years inflation has been driven down by all three factors, as the effective lower bound to policy rates has prevented the European Central Bank from reducing the short-term rates to support economic activity and align inflation with the definition of price stability. Remarkably, the joint contribution of monetary and demand shocks is at least as important as that of oil price developments to the deviation of inflation from its baseline. Country-by-country analysis shows that both aggregate demand and oil supply shocks have driven inflation down everywhere, albeit with varying intensity. The findings stand confirmed after a series of robustness checks.

Keywords: oil supply; monetary policy; inflation; VAR models; Bayesian methods (search for similar items in EconPapers)
JEL-codes: C32 E31 E32 E52 (search for similar items in EconPapers)
Date: 2015-07
New Economics Papers: this item is included in nep-cba, nep-eec, nep-mac and nep-mon
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