Euro Area and Inflation Differentials: Evidence from a Dynamic Panel Data Model

One of the main objectives of the European Central Bank (ECB) is price stability and it does not focus on inflation in individual countries in the euro area. However, many years after the launch of the euro, inflation differentials among euro area countries are still subject to debate. Inflation differentials are a normal phenomenon in any monetary union and even in long-established monetary unions like the United States differences in regional inflation rates are observed. By comparison, national inflation differentials in the euro area are not unusually large. The aim of this paper is to examine the main factors of inflation differentials in Eurozone. We use data for the nineteen euro area countries over the EMU for the period 1999-2018. Our baseline proxy for the Balassa-Samuelson effects is constructed as the annual growth rate of labour productivity in the business sector. The output gap is obtained using the Hodrick-Prescott filter (with a smoothing parameter set to 30) on initial series of GDP at constant price. The indicator for the exchange rates variations is constructed as the growth rate of the nominal effective exchange rate weighted by the ratio of imports to GDP. All the data are taken from Eurostat and are in quarterly frequency. The results were based on a panel data model using OLS and GMM estimators. The major factors of these divergences among member - countries are the Balassa-Samuelson effect (defined as productivity growth) and the nominal effective exchange rates deviations. Our empirical estimates appear to suggest that one-percentage-point increase in the positive output gap typically leads to an increase of about 20 basis points in the inflation rate of EMU countries. Also the growing interest of the ECB regarding national inflation differentials within the euro area clearly reveals its concern about the potential implications of such lasting inflation disparities. Since the monetary policy of the ECB is geared at maintaining a low and stable inflation, the productivity growth should be increased and the exchange rates should be decreased and become more homogenous among EMU. Therefore countries inflation differentials may become less persistent.