Persistent inflation differentials in Europe

Eva Ortega

Economic Bulletin, 2003, issue JAN, No 3, 75 pages

Abstract: In recent years there has been a widespread decline in inflation rates in the euro area countries, accompanied by the progressive convergence of such rates. However, the differences between these inflation rates have not only not disappeared but have in fact held stable since the start-up of Economic and Monetary Union (EMU). Chart 1 highlights the persistence of these differentials between the main euro area economies during the past decade. Numerous studies in recent years have addressed the inflation differentials between countries. According to the Balassa-Samuelson (BS) hypothesis, inflation differentials are directly linked to developments in each economy in respect of relative prices in their sheltered or nontradeable sectors as opposed to their tradeable sectors. These relative prices, in turn, are linked to differences in productivity across the various sectors. As a result, inflation differentials do not necessarily entail changes in the relative competitiveness of economies, as it is the most inflationary countries which see the highest growth in relative productivity. This article reviews the empirical evidence over the past two decades for Spain, Germany, Italy and France, breaking down changes in relative prices between tradeables and non-tradeables into relative changes in markups, labour costs and labour productivity. The analysis focuses on studying whether there are persistent differences – and their source – in the long-term growth of relative prices between the main European economies and, in particular, whether the effect of changes in relative productivity is, as the B-S hypothesis indicates, predominant. Were this not the case, inflation differentials might be reflecting changes in the relative competitiveness of European economies. Section 2 presents the analytical framework used and the data employed. Section 3 describes the results obtained from exploring the data, and section 4 draws some conclusions.

Date: 2003
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