Is there scope for inflation differentials in EMU?

Enrique Alberola

Economic Bulletin, 1999, issue JAN, No 4, 69-73

Abstract: Economic and Monetary Union (EMU) entails the de facto disappearance of bilateral exchange rates between the participating countries and the establishment of a single monetary policy managed by the European Central Bank (ECB). The independence of the ECB and its primary objective of price stability mean that the future European inflation rate can be expected to be similar to that of the countries that have historically enjoyed greater monetary stability. This, moreover, is what the nominal convergence that has taken place in recent years would suggest. Nonetheless, the existence of a single monetary policy does not rule out the possibility of inflation differentials within EMU. EMU eliminates monetary divergences, but this would only entail a uniform rate of inflation if it is accepted that inflation is a purely monetary phenomenon. However, even with a common currency, differences will persist in the economic structure, growth rate and labour and product markets of each country. These real factors have effects on the relative prices between countries, and may generate lasting inflation differentials. The purpose of this article is to explore the role that real factors may play and to quantify the magnitude of the potential inflation differentials between countries within EMU. It must be emphasised however, that the differentials are calculated by extrapolating past trends, so that the significant effects that monetary union may have on the workings of the national economies are not taken into account. Consequently, the estimates presented may be taken as an upper limit to the differentials that may arise in Stage Three of EMU. The following section describes the mechanism whereby inflation differentials may arise within a monetary union, and afterwards the results of the estimation are presented. Finally, the results are briefly interpreted and evaluated for the case of Spain.

Date: 1999
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