Academic journal article Economic Quarterly - Federal Reserve Bank of Richmond

The Euro and Inflation Divergence in Europe

Academic journal article Economic Quarterly - Federal Reserve Bank of Richmond

The Euro and Inflation Divergence in Europe

Article excerpt

In January 1999, eleven European countries abandoned their respective national currencies and monetary independence to adopt a common currency, the Euro.1 This event, in which several industrialized countries formed a currency union, stands out in modern monetary history by its uniqueness, and in due time, it will allow for a better understanding of the implications of different monetary arrangements among countries. Already, with four years of data available, we can begin to learn from Europe's natural experiment.

In a flexible exchange rate regime, the equilibrium adjustment in the relative price across countries associated with a given country-specific shock results both from movements in nominal prices and from movements in the relative price of the countries' currencies, i.e., the nominal exchange rate. In a currency union, movements in the nominal exchange rate are, by definition, no longer possible, and equilibrium adjustments in the relative price across countries result only from movements in nominal prices.2 In addition, countries in a currency union can no longer use monetary policy in response to such a shock. The equilibrium adjustment of nominal prices associated with a given country-specific shock reflects, among other factors, not only the degree of asymmetry of the shock but also the degree of integration of the different regions (namely, the mobility of factors of production or the ability to automatically transfer resources across regions). The more asymmetric the shock or the less integrated the different regions in a currency union, the bigger the equilibrium adjustment associated with a given shock. Hence, inflation differentials can be seen as an indicator of regional asymmetries within a currency union.3

In this article I document the behavior of inflation dispersion and inflation differentials in Euro-area countries before and after the introduction of the Euro. This documentation supports the main message of the article: that inflation dispersion and inflation differentials (with respect to German inflation) within the Euro area have increased after the adoption of the common currency. Moreover, inflation dispersion in the Euro area has been higher than that observed in the United States. Assessing the sources of inflation divergence in the Euro area after 1999 suggests that countries with higher inflation rates tend to have also had higher GDP growth rates and a lower price level when the Euro was adopted. Finally, the variability of the inflation differential with respect to German inflation has tended to increase for most countries after the Euro was adopted.

This article is organized as follows. In section 1 I briefly review the process leading to the implementation of the European Monetary Union (EMU). In Section 2 I provide a general discussion about currency unions, and in Section 3 I document the behavior of inflation before and after the Euro was adopted using twelve-month core CPI inflation data from the eleven countries that adopted the common currency in January 1999. In the final section I state my conclusions.

1. A BRIEF REVIEW OF THE ROAD TO THE EMU

The process of European integration started shortly after World War II, stimulated by the idea that a unified Europe would help ensure peace. In 1950 Robert Schuman, France's foreign minister, proposed that the coal and steel industries of France and Germany (then West Germany) be coordinated under a single supranational authority. This initiative lead to the European Steel and Coal Community, formed in 1952 together with Belgium, Italy, Luxembourg, and the Netherlands. Building on the success of this organization, the European Economic Community and the European Atomic Energy Community were established in 1957 by the Treaty of Rome. These three organizations were later consolidated in 1967 to form the European Community (EC), known as European Union (EU) since the ratification of the Maastricht Treaty in 1992. …

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