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Inflation Differentials in the Euro Area: A Survey

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The European Central Bank at Ten

Abstract

The objective of the European Central Bank (ECB) is price stability, which the ECB has defined as an inflation rate in the euro area in the medium run that is below but close to 2%. The ECB does not focus on inflation in individual countries in the euro area. However, several years after the launch of the euro, inflation differentials among euro area countries are still subject to much debate. After converging sharply in the 1990s, national inflation rates started to diverge again in 1999; since then, the standard deviation of the annual inflation rates among euro area members has fluctuated around 1%—a substantial figure (Angeloni & Ehrmann 2007).

The views expressed in this chapter are those of the author and should not be attributed to De Nederlandsche Bank.

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Notes

  1. 1.

    However, what matters for investment and consumption decisions are ex ante measures of real interest rates, i.e., the difference between market interest rates and expectations for inflation developments over the relevant horizon. The dispersion across countries of ex ante measures of real interest rates is significantly lower than that of ex post measures (European Central Bank 2005).

  2. 2.

    The data refer to the current countries in the euro area. I am thankful to Lourdes Acedo-Montoya from the European Commission (DG ECFIN) for providing these data.

  3. 3.

    As pointed out by Rabanal (2009), the Balassa–Samuelson hypothesis could explain the higher inflation rate in the service sector (as a proxy for the non-tradable sector) than in the goods sector (as a proxy for the tradable sector).

  4. 4.

    It may be argued that the Balassa–Samaulson effect may be more relevant for the new EU member states. However, according to Égert and Podpiera (2008), for the Czech Republic, Hungary, Poland, and Slovakia the relevant literature over the past 5 years failed to quantify a sizable Balassa–Samuelson effect, with the average effect from 20 recent studies accounting at best for one-third of the actual real exchange rate appreciation of more than 30% from 1995 to 2006. However, Mihaljek and Klau (2008) conclude that the Balassa–Samuelson effects are clearly present and explain around 24% of inflation differentials vis-à-vis the euro area (about 1.2% points on average) in their sample of 11 countries in central and eastern Europe covering the period from the mid-1990s to the first quarter of 2008.

  5. 5.

    Inflation data come from the ECB, while the output gap data come from EconStats. The data for Ireland and the Netherlands run to 2006 only.

  6. 6.

    This effect also occurs in relationship to countries outside the monetary union. Since the euro’s (flexible) nominal exchange rate against the currencies of such countries is geared to economic developments of the euro area as a whole, euro-area countries with an above-average inflation rate see their competitive position vis-à-vis non-euro-area countries decline, while euro-area countries with a below-average inflation rate see their competitive position improve (Remsperger 2003).

  7. 7.

    Financial integration may provide for insurance against asymmetric shocks. If residents of the member countries of a monetary union hold monetary union-wide diversified portfolios the costs of asymmetric shocks will be born by all residents (Beck et al. 2009). However, as De Haan, Oosterloo, and Schoenmaker (2009) show, despite substantial progress in financial integration in Europe, portfolios of many European financial institutions are still characterized by a high home bias.

  8. 8.

    Asymmetric shocks and differences in the transmission of and the policy reaction to common shocks are, of course, among the driving forces of diverging business cycles.

  9. 9.

    These factors can be related. According to the European Central Bank (2005), euro area energy and unprocessed food prices seem to change most frequently, while service prices appear to be modified less frequently.

  10. 10.

    Evidence presented by Dhyne, Alvarez, Le Bihan, Veronese, Dias, Hoffmann, Jonker, Lünnemann, Rumler, and Vilmunen (2006) for the euro area suggests that prices are changed on average every 13 months.

  11. 11.

    In Sect. 2.5 we will discuss some recent research on labour market reform that aims to increase labour market flexibility.

  12. 12.

    Fendel and Frenkel (2009) examine whether inflation differentials have influenced the behaviour of the ECB since the launch of the euro. They hypothesise that the ECB may have been less restrictive than euro area wide developments would dictate thereby preventing deflation in the low inflation countries. Their Taylor rule model outcomes suggest an influence of inflation differentials on monetary policy in the euro area. With higher inflation divergence, the ECB was more reluctant to fight an overall inflation gap.

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Authors and Affiliations

  1. Research Department, De Nederlandsche Bank, Amsterdam, PO BOX 98, 1000 AB, The Netherlands

    Jakob de Haan

  2. University of Groningen, Groningen, The Netherlands

    Jakob de Haan

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  1. , Research, De Nederlandsche Bank, Amsterdam, 1000 AB, Netherlands

    Jakob Haan

  2. , European Department, International Monetary Fund, 19th Street NW 700, Washington, DC, 20431, USA

    Helge Berger

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de Haan, J. (2010). Inflation Differentials in the Euro Area: A Survey. In: Haan, J., Berger, H. (eds) The European Central Bank at Ten. Springer, Berlin, Heidelberg. https://doi.org/10.1007/978-3-642-14237-6_2

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