Catching-up and inflation in Europe: Balassa-Samuelson, Engel's Law and other culprits

This study analyses the impact of economic catching-up on annual inflation rates in the European Union with a special focus on the new member countries of Central and Eastern Europe. Using an array of estimation methods, we show that the Balassa-Samuelson effect is not an important driver of inflation rates. By contrast, we find that the initial price level and regulated prices strongly affect inflation outcomes in a nonlinear manner and that the extension of Engel's Law may hold during periods of very fast growth. We interpret these results as a sign that price level convergence comes from goods, market and non-market service prices. Furthermore, we find that the Phillips curve flattens with a decline in the inflation rate, that inflation is more persistent and that commodity prices have a stronger effect on inflation in a higher inflation environment.

Research highlights► Balassa-Samuelson effect is not important driver of inflation rates in EU and CEEE countries. ► Initial price level and regulated prices affect inflation in a nonlinear manner. ► The extension of Engel's Law holds when economic growth is fast. ► These results suggest that price level convergence comes from both goods and service prices. ► Inflation is more persistent and commodity prices affect inflation more strongly if inflation is high.