Abstract
The stability of inflation differentials is an important condition for the smooth working of a currency area, such as the European Economic and Monetary Union. In the presence of stability, changes in national inflation rates, while holding Euro area inflation fixed contemporaneously, should be only transitory. If this is the case, the rate of inflation of the whole area can also be interpreted as a predictor, at least in the long-run, of the different national inflation rates. However, in this paper we show that this condition is satisfied only for a small number of countries, including France and Italy. Better convergence results for inflation differentials are, instead, found for the USA. Some policy implications are drawn for the Eurozone.
Highlights
Inflation differentials often characterize large currency areas, such as the European Economic and Monetary Union (EMU) or the United States
The stability of inflation differentials is an important condition for the smooth working of a currency area, such as the European Economic and Monetary Union
In the context of stochastic processes, and in the presence of series which exhibit a unit root, this requires that the Euro-area inflation and the national inflation rate should be driven by a common stochastic trend, i.e. the inflation differential should behave as a stationary variable
Summary
Inflation differentials often characterize large currency areas, such as the European Economic and Monetary Union (EMU) or the United States. A somewhat different conclusion has recently been reached by Fendel and Frenkel (2009), since the authors find evidence of attention paid by the ECB to inflation differentials among countries They maintain that considering this variable might have induced the central bank to a less restrictive stance than required by the macroeconomic conditions of the Euro area in the first years of activity. Belgium, France and Italy exhibit an inflation path converging to the EMU average annual rate For these countries we recover the structural shocks associated with the joint, bivariate dynamics of Eurozone inflation and national inflation.
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