Determinants of Inflation Differentials in the Euro Area: Is the New Keynesian Phillips Curve Enough?

Abstract

In the euro area, inflation rates diverged after the creation of the single currency, and started to converge again from mid-2002. It is against this background that the paper studies the determinants of inflation differentials in the euro area. We start by using the New Keynesian Phillips Curve (NKPC) to explain inflation differences for a panel of countries. Exchange rate movements and expected inflation in particular play an important part in bringing about diverging inflation dynamics, while lagged inflation does not. The Incomplete Competition Model (ICM) adds explanatory power to the NKPC in describing inflation dynamics across countries. The latter model does not encompass ICM, and the variables proposed by the ICM are statistically significant: the growth in nominal Unit Labour Cost and the long-run disequilibrium between prices and costs explain inflation differentials.