Abstract
The literature on optimum currency areas states that large inflation differentials can undermine monetary union. In the euro area, inflation rates diverged after the creation of the single currency, but started to converge again from mid-2002. Against this background, we assess the convergence of inflation rates and business cycles and study the relationship between them. The analysis is made using an unobserved component model estimated with the Kalman filter. In general, from 1980 to 2008 inflation rates and business cycles became more aligned in the euro area, but inflation rates converged more quickly than business cycles. The output gap is found to be a better indicator of the business cycle than unit labour cost when studying convergence. By looking at the causality between the convergence of inflation and output gap, it is found that inflation divergence has a limited destabilising economic impact.
Highlights
As stressed by the optimum currency area literature, large inflation differentials can undermine the success of a monetary union (Tavlas 1994)
Our results indicate that inflation differentials in the euro area converged in expectation from 1980 to 2008
This paper addresses two major issues: assessing the convergence of inflation rates and business cycles in the euro area, and studying the relationship between these conver-gence processes
Summary
As stressed by the optimum currency area literature, large inflation differentials can undermine the success of a monetary union (Tavlas 1994). The main goal of this paper is to study the association between these two convergence processes, namely we want to examine whether divergence (convergence) in inflation rates after the. Lagoa introduction of the euro can be explained by divergence (convergence) in business cycles. Since the creation of the European Exchange Rate Mechanism (ERM) in 1979, there has been evidence that monetary policy convergence in the euro area has been accompanied by inflation convergence. Due to the nominal convergence required by the Maastricht Criteria, the cross-sectional standard deviation of inflation rates in the euro area decreased to 0.6 % in September 1999. In the first years of the euro (1999–2002), the countries with highest inflation rates were Greece, Ireland, the Netherlands, Portugal and Spain
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