Explaining Inflation Differentials between Spain and the Euro Area

Abstract

This paper investigates the behavior of inflation differentials between Spain and the rest of the euro area member countries. Cross country studies of inflation differentials, and in particular in the EMU, have focused on three explanations: (i) the role of tradable and nontradable sector productivity improvements, and the Balassa-Samuelson effect, (ii) the role of the demand-side effects, and (iii) heterogeneity of inflationary processes inside the EMU. First, the paper documents that, during the 2002-2006 period, inflation differentials in the tradable goods sector have been driving the inflation differentials in the headline HICP inflation. Second, the paper uses the estimates of a two country, two sector Dynamic Stochastic General Equilibrium (DSGE) model with nominal rigidities in a currency union using data for Spain and the euro area, to understand the role of each feature in shaping inflation differentials. The paper finds that fluctuations in productivity improvements in the tradable sector are the most important source of headline HICP inflation differentials. Demand shocks help explain a fraction of output growth, but not of inflation dispersion. In addition, the estimated model finds no evidence that inflation dynamics are different in Spain and in the rest of the euro area.