Revisiting the relative price mechanism

Philipp Mohl and Thomas Walsh

Quarterly Report on the Euro Area (QREA), 2016, vol. 14, issue 4, 19-32

Abstract: In the absence of national exchange rates, euro area Member States need to respond to asymmetric shocks via internal adjustment processes. This section analyses the functioning of a key built-in internal adjustment process in EMU, namely the "relative price mechanism" (frequently called the "competitiveness channel"), which links price developments to both the cyclical phases of the business cycle as well as to structural developments. The findings of panel data estimations suggest that the relative price mechanism has indeed worked since the launch of the euro: differentials in cyclical conditions and structural reforms have contributed to closing price differentials across the euro area. The observed relative price mechanism is stronger when measured using unit labour costs (ULCs) compared with the GDP deflator, which could be explained by the fact that many Member States are (small) open economies acting as price takers. ULCs are determined largely by domestic factors, while the GDP deflator is also influenced by world prices, especially when exporters act as price takers. In the post-2009 period, however, the relative price mechanism has acted with a delay, kicking in only after the start of the European debt crisis in 2011. The response to output gap differentials was more rapid in the private than in the public sector when ULCs are calculated separately for the two sectors. Furthermore, the functioning of the mechanisms has remained hampered by structural rigidities, in particular in the national labour, product and financial markets. The wider related literature suggests that, due to downward nominal rigidities, price adjustment could be stronger once the euro area moves out of the current low inflation environment. Overall, the findings stress the relevance of structural reforms in both vulnerable and core countries not only for raising growth potential, but also for accelerating the adjustment to asymmetric shocks in euro-area countries.

Keywords: relative; price; adjustment (search for similar items in EconPapers)
Date: 2016
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Persistent link: https://EconPapers.repec.org/RePEc:euf:qreuro:0144-02

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