Interpreting inflation differentials in the euro area

Enrique Alberola

Economic Bulletin, 2000, issue APR, No 3, 70 pages

Abstract: Since the start of Economic and Monetary Union (EMU), inflation differentials between the euro area countries have persisted, standing at around one percentage point in 1999. The differentials are relatively small and the evidence is that inflation differences on this scale are not infrequent between the regions of a country. But analysis of the determinants of divergent price developments between euro area countries is important for at least two reasons. First, inflation differentials in the euro area may be due both to (i) factors relating to disequilibrium and rigidities in the economy, in which case greater inflation would translate into a loss in competitiveness; and (ii) to a process of real and productivity-related convergence by the less developed countries towards the European average, where the inflation differentials would not prompt losses in competitiveness or macroeconomic disequilibria. These interpretations give rise to opposing views on the nature [worrying in (i), more benign in (ii)] of inflation differentials in a monetary union. Second, in a monetary union there is, by definition, no possibility of carrying out nominal adjustments domestically via monetary policy or the devaluation of the exchange rate. Were inflation differentials attributed to the more negative interpretation, i.e. were they to be associated with the existence of rigidities and disequilibria in the economy, there would be reasons for expecting the subsequent adjustment to have greater effects in real terms than when an autonomous monetary and exchange rate policy were in place. This article considers the theoretical arguments behind the two foregoing interpretations so as to assess as far as possible the nature of the inflation differences observed since the adoption of the single currency. One conclusion to emerge from the analysis is that the inflation differentials observed have arisen from both favourable and unfavourable factors, the relative significance of which is, unfortunately, difficult to quantify. In general, sustained processes of real convergence can be affirmed to be accompanied in the medium term by positive inflation differentials in relation to the more developed countries of the area. However, if the differentials are excessive, in that they reflect the influence of the inadequate functioning of markets or of demand-side disequilibria, convergence may be jeopardised.

Date: 2000
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