Inflation differentials among the Euro area countries: Potential causes and consequences

In this paper we review the development, potential causes and macroeconomic implications of inflation differentials in the euro area. We also present some new evidence based on an estimated New Keynesian style model of the euro area economies. Our empirical analysis suggests that the observed inflation differentials since the start of EMU were mainly driven by temporary shocks combined with a rather high level of inflation persistence. The scope for an amplification of inflation differentials via corresponding real interest rate differentials appears to be limited by the presence of significant real exchange rate and direct output spill-over effects in the euro area IS Curves. We also find that inflation persistence is significantly lower, virtually zero, in the group of euro area countries which have already experienced comparably low and stable inflation rates in the past. Since the monetary policy of the Eurosystem is geared at delivering and maintaining low and stable inflation rates, inflation persistence should also decrease in the other countries, which would in turn mitigate the persistence of euro area inflation differentials.