The continuous-time approach to macroeconomic modelling with an application to the Italian economy

This contribution is made up of two parts. The first is devoted to a short review of the advantages of continuous time modelling over the discrete time modelling in the specification of macroeconomic models. A basic issue concerning the specification of macroeconomic models is whether they should be specified in continuous or discrete time. Although it is likely that an economy might be best represented by a set of non-linear mixed difference/differential equations, the analysis of such a system is at present intractable. If a choice has to be made, we think that a continuous discrete model gives a better representation. A number of advantages that we briefly summarize motivates this choice. In the second part, we estimate a dynamic disequilibrium model of the Italian economy to explore some relevant features characterizing its evolution in the last three decades, such as the stagnant labor productivity, the decline of the wage share and the weak impact of the information and communication technology (ICT) on the total factor productivity (TFP). The modelling strategy is based on the distinction between traditional and ICT capital. The model behaves quite well in replicating the dynamics of the Italian economy. It also shows however that there remains some structural inefficiency, worsened in recent years. In fact, our main finding shows that there exists a permanent gap between “optimal” and actual output, which increased in the latter part of the sample period. While a fraction of this gap can be attributed to unavoidable (market and non-market) adjustment costs, some is associated to efficiency losses.