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Master  Thesis   Master  Economics  

Faculty  of  Economics  and  Business  

Specialization:  International  economics  and  globalization  

Inflation  differentials  in  the  Euro  area  countries  

(EMU-­‐12)  before  and  after  the  credit  crisis  of  2007  

Name:  Sebastiaan  Blom   Student  number:  10384812  

E-­‐mail:  sebastiaanblom@hotmail.com   Supervisor:  Dr.  Maja  Micevska  Scharf       Second  reader:  Dr.  Dirk  Veestraeten   Date  of  submission:  16-­‐08-­‐2015  

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Abstract

Within the Economic and Monetary Union (EMU), differences in inflation rates (inflation differentials) between member states cannot be corrected easily. Hence, inflation differentials and the underlying determinants are an important topic to investigate. This thesis presents a descriptive, theoretical and empirical analysis of inflation differentials in the EMU-12 before and after the 2007 credit crisis. It categorizes the potential determinants of inflation divergences into cyclical factors, convergence effects, external factors and market rigidities. The research contributes to the current literature in two ways. Firstly, it extends the analysis to the years after the crisis and explicitly compares the pre- and post-crisis years. Secondly, it introduces a variable measuring labour market flexibility. The empirical analysis combines the approaches of Honohan and Lane (2003) and Licheron (2007) by using a dynamic panel regression model, which takes into account the role of inflation persistence, to be estimated by system-GMM (also known as the Blundell and Bond estimator). The baseline results on the relative importance of the four categories of potential determinants suggest that external factors and market rigidities do not play an important role in explaining EMU-12 inflation differentials in either period. The results on cyclical factors and convergence effects are ambivalent. The importance of inflation persistence seems to have decreased in recent years. The results should be viewed with caution, as they are sensitive to changes in estimation methodology.

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Table of contents

1. Introduction 4

2. Inflation differentials in the EMU 6

2.1 Descriptive analysis of inflation differentials in the EMU 6

2.2 Why do inflation differentials matter? 11

2.3 Determinants of inflation differentials 15

2.3.1 Cyclical factors 16

2.3.2 Convergence effects 18

2.3.3 External factors 20

2.3.4 Market rigidities – labour market flexibility 21

2.4 Sub-conclusion 24 3. Empirical analysis 25 3.1 Data 25 3.1.1 Dependent variable 25 3.1.2 Independent variables 25 3.2 Empirical method 28 3.3 Results 32 3.3.1 Baseline results 32 3.3.2 Robustness checks 38

3.3.3 Discussion and specification issues 41

4. Conclusion 42

5. References 45

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1. Introduction

Within the Economic and Monetary Union (EMU), differences in inflation rates (inflation differentials) between member states cannot be corrected easily. In a monetary union like the EMU, it is no longer possible to adjust nominal exchange rates in response to shocks (Aldasoro and Žďárek, 2009). Hence, inflation differentials and the underlying determinants are an important topic to investigate.

The European Central Bank (ECB) sets the nominal interest rate based on the Eurozone inflation rate, but national inflation rates can still differ. Inflation divergences cause diverging real interest rates, complicating the implementation of a common monetary policy (Gregoriou et al., 2006). In addition, inflation differentials will directly affect the real exchange rate of member states, and hence their relative competitive position (Aldasoro and Žďárek, 2009). Regaining competitiveness in a monetary union then can only happen via adjustments of relative prices. According to Mundell (as noted in Zemanek, 2010), labour market flexibility plays an essential role in the process of ‘internal devaluation’. It involves lowering wages, leading to a lower general (relative) price level, and hence causing a real depreciation. This could then lead to an improvement of the current account balance as a real depreciation makes exports cheaper and imports more expensive. Internal devaluation is especially important in the EMU because of some particular institutional features such as the lack of a strong fiscal transfer system, also referred to as interregional smoothing mechanisms (Aldasoro and Žďárek, 2009; Zemanek, 2010). Moreover, relative price and wage adjustment can take place via trade and labour migration. But these mechanisms only work well in the absence of price and wage rigidity. This is hampered in case of the EMU by e.g. weak migration and labour mobility (Aldasoro and Žďárek, 2009; Zemanek, 2010).

Therefore, it is essential to understand why inflation rates keep diverging in the EMU. Do inflation differentials reflect a process of convergence of price levels and productivity growth? This would mean that divergences are likely to slowly disappear, although there is no agreement on how long this could take, especially in light of new countries adopting the euro. In contrast, if inflation divergences were to reflect structural differences, this would mean that they could be long lasting and more problematic. This thesis focuses on the underlying explanations of inflation differentials in the Euro area. Many potential determinants have been put forward in the literature.

My research will contribute to the current literature in two ways. Firstly, it will extend the analysis to the years after the credit crisis of 2007 and explicitly compare the pre- and

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post-crisis period1. This could provide interesting results as the credit crisis has led to fiscal,

financial, and structural reforms in the EMU countries that were characterized by the build-up of large imbalances and inflation differentials (ECB, 2012). Before the crisis, countries like Portugal, Spain, Ireland and Greece were characterized by persistent positive inflation differentials, whereas other member states such as Belgium, Germany and Austria were experiencing persistent negative inflation differentials. There have been some important reversals in these trends after 2007. Secondly, this thesis will add a variable measuring labour market flexibility, as only a few papers have tried to do so. A lack of labour market flexibility in certain member states, causing downward wage and price rigidity, is likely to have contributed to EMU inflation differentials (Jaumotte and Morsy, 2012). The asymmetric effects of the 2007 crisis on the EMU member states and the associated build-up of external imbalances have highlighted the importance of labour market reforms in order to smooth adjustments of shocks in the currency union (Turrini et al., 2014). Hence, it might be expected that the role of labour market flexibility in explaining inflation differentials has changed.

The main research question of this thesis is: What are the main determinants of

inflation differentials in the EMU in the pre- and post-2007/2008 period?

In order to be able to make a valid comparison between the 1999-2007 and 2008-2013 period, I will focus on the EMU-12 countries2. This thesis consists of two parts. The first part

provides a descriptive and theoretical analysis. It presents a descriptive analysis of inflation differentials in the EMU before and after 2007. This part also discusses why inflation differentials in a currency union matter. In addition, it will provide an overview of the most important determinants of inflation differentials discussed in the literature. I will establish what is lacking (analysis of labour market flexibility) and why it might be expected that some determinants affect inflation differentials differently before and after the crisis. The second part of the thesis will perform an empirical analysis on the determinants of inflation divergences in the EMU-12. This will be done by combining the approaches of Honohan and Lane (2003) and Licheron (2007), using a dynamic panel regression model to be estimated by system-GMM (also known as the Blundell and Bond estimator).

                                                                                                                         

1 Based on the availability of data, the analysis is extended up until 2013.  

2 I decided to include Greece even though it adopted the Euro in 2001 (instead of in 1999 as the other countries

included in the research). Greece has been one of the euro countries that was hit hardest by the crisis and that might be expected to have implemented significant structural (labour market) reforms. Hence, excluding Greece could significantly alter my results.

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2. Inflation differentials in the EMU

The literature on the determinants of inflation differentials in the EMU can be broadly divided into three strands. The first strand uses New Keynesian calibrated models with microeconomic foundations to establish theoretical features of currency unions in a stylized manner. Most of these models assume two countries, which is a huge simplification of the dynamics of the EMU (e.g. Altissimo et al., 2005). Other scholars, such as Angeloni and Ehrmann (2004) and Hofmann and Remsperger (2005), have tried to build stylized models incorporating all Euro area countries. The second strand of literature examines inflation determinants in a descriptive analysis in combination with (panel) regression analysis or correlation results. Honohan and Lane (2003) are considered to be pioneers in this area and many scholars have subsequently followed their methodology (e.g. Licheron, 2007; Aldasoro and Žďárek, 2009). The third strand, which is less widely applied, uses unit root tests in order to analyze time series features of inflation divergences (e.g. Gregoriou et al., 2011). This strand specifically focuses on the persistence of inflation differentials (as noted in Aldasoro and Žďárek, 2009).

My research falls under the second strand, but it does take into account some of the potential determinants of inflation differentials that have been suggested in the other strands of literature. This chapter consists of a descriptive and theoretical analysis of inflation differentials. The first section will provide a descriptive analysis of inflation divergences in the EMU since its establishment in 1999. The second section will discuss why inflation differentials matter. The third section analyzes the potential determinants that have been discussed in the literature. It will also establish why it might be expected that some of these determinants have changed since 2008. Lastly, this section will emphasize the relevance of including a proxy for labour market flexibility in the regression, as this is an important extension of the research.

2.1 Descriptive analysis of inflation differentials in the EMU

One of the main contributions of this thesis to the existing literature will be to include the years after the 2007 credit crisis in the analysis and to compare the impact of determinants of inflation differentials in the period 1999-2007 to the period 2008-2013. This section will establish some trends in EMU inflation differentials during these two periods, based on a descriptive analysis of EMU HICP-inflation (Harmonized Index of Consumer Prices) data from Eurostat, which will motivate my research.

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Figure 1 shows the degree of inflation dispersion3 in the EMU-12 from January 1997

up until December 2013, as measured by the unweighted standard deviation4. After a significant decrease to levels close to one in the years up until the implementation of the euro in 1999, inflation dispersion increased for a couple of years before steadily decreasing until the 2007 credit crisis. In the years after the crisis, dispersion increased markedly to levels that had not been seen since the creation of the EMU, before coming down again in 2011. But as can be seen in the graph, especially taking into account a sharp increase in the second half of 2013, it is hard to predict the path of inflation dispersion in the coming years.

Figure 1: Inflation dispersion in the euro area (EMU-12)

Source: Eurostat, own calculations based on HICP (2005=100) – monthly data (annual rate of change).

In order to put the EMU-12 levels of inflation dispersion into perspective, some scholars have compared the path of dispersion to that in the United States (also a currency union) (e.g. ECB, 2003; Whelan, 2014). I find this of limited use for my thesis as these currency unions differ significantly, for example in terms of institutional structures. Instead, the next graphs and tables will establish the pattern of inflation differentials in individual member states in order to discern some trends that might be relevant for this research.

                                                                                                                         

3 Inflation dispersion measures to what extent inflation differs across countries at a certain point in time (ECB,

2003).

4 This is one of the most commonly used indicators of inflation dispersion because it is a summary indicator of

the value of the standard inflation differential across countries, in this case the EMU-12 member states. Some other indicators that are frequently used are the weighted standard deviation, the coefficient of variation and the spread. Each one of them has certain advantages and drawbacks. According to the ECB, they show similar trends in case of the EMU (ECB, 2003).

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Figure 2: Monthly HICP-inflation rates EMU-12

Source: Eurostat, graph made in excel based on HICP (2005=100) – monthly data (annual rate of change).

Figure 2 shows the year-over-year HICP-inflation rates (on a monthly basis) for the EMU-12 member states from January 19975 up until December 2013. Some general trends can be established. Firstly, inflation rates were relatively stable in most countries in the years preceding the crisis. But in 2008, amidst the outbreak of the global crisis, inflation rates significantly increased. This is counterintuitive as one would expect inflation rates to decrease during the crisis. According to Whelan (2014), the rise can be explained by a sharp increase in oil prices in 2008. The 2009 global recession then causes the expected collapse of inflation rates. Since 2009, inflation rates first started to rise again before decreasing markedly in recent years. Secondly, the graph discerns some interesting patterns regarding certain (groups of) member states. For example, countries like Greece, Ireland and Spain (and to a lesser extent Portugal; it is difficult to see) were characterized by high inflation rates up until the crisis, higher than the EMU-12 average (roughly analyzed based on figure 2). These are also some of the member states that were hit hardest by the crisis. Other countries like Germany and Finland, were characterized by inflation rates below the EMU-12 average before the crisis. In the post-crisis years, this trend has ended. Greece and Ireland even record inflation rates persistently below the EMU-12 average in recent years.

                                                                                                                         

5 Eurostat HICP inflation rates are available starting in 1996, hence the first year-over-year HICP inflation rates

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Table 1: Inflation differentials across countries relative to the EMU-12 average 1999-2007. GEO/TIME 1999-2007 1999 2000 2001 2002 2003 2004 2005 2006 2007 Belgium -0,4 -0,3 -0,1 -0,6 -1,2 -0,9 -0,3 0,2 -0,1 -0,4 Germany -0,8 -0,8 -1,4 -1,1 -1,4 -1,4 -0,4 -0,4 -0,6 0,1 Ireland 1,0 1,1 2,5 1,0 1,9 1,6 0,1 -0,1 0,3 0,7 Greece 0,8 0,7 0,1 0,7 1,1 1,0 0,8 1,2 0,9 0,8 Spain 0,7 0,8 0,7 -0,2 0,8 0,7 0,9 1,1 1,2 0,6 France -0,6 -0,8 -1,0 -1,2 -0,9 -0,2 0,1 -0,4 -0,5 -0,6 Italy -0,1 0,3 -0,2 -0,7 -0,2 0,4 0,1 -0,1 -0,2 -0,2 Luxembourg 0,3 -0,4 1,0 -0,6 -0,7 0,1 1,0 1,5 0,6 0,5 Netherlands 0,0 0,6 -0,5 2,1 1,1 -0,2 -0,8 -0,8 -0,7 -0,6 Austria -0,6 -0,9 -0,8 -0,7 -1,1 -1,1 -0,2 -0,2 -0,7 0,0 Portugal 0,5 0,8 0,0 1,4 0,9 0,9 0,3 -0,2 0,6 0,2 Finland -0,8 -0,1 0,1 -0,3 -0,8 -1,1 -2,1 -1,5 -1,1 -0,6

Source: Eurostat, own calculations in excel based on HICP (2005=100) – annual data (annual average rate of change).

Table 2: Inflation differentials across countries relative to the EMU-12 average 2008-2013.

GEO/TIME 2008-2013 2008 2009 2010 2011 2012 2013 Belgium 0,3 1,0 -0,2 0,6 0,5 0,1 -0,1 Germany -0,3 -0,7 0,0 -0,5 -0,4 -0,4 0,3 Ireland -1,4 -0,4 -1,9 -3,3 -1,7 -0,6 -0,8 Greece 0,8 0,7 1,1 3,0 0,2 -1,5 -2,2 Spain 0,7 0,6 -0,4 0,3 0,2 -0,1 0,2 France -0,3 -0,3 -0,1 0,0 -0,6 -0,3 -0,3 Italy 0,2 0,0 0,6 -0,1 0,0 0,8 0,0 Luxembourg 0,5 0,6 -0,2 1,1 0,8 0,4 0,4 Netherlands 0,0 -1,3 0,8 -0,8 -0,4 0,3 1,3 Austria 0,3 -0,3 0,2 0,0 0,7 0,1 0,8 Portugal -0,3 -0,8 -1,1 -0,3 0,7 0,3 -0,9 Finland 0,6 0,4 1,4 0,0 0,4 0,7 0,9

Source: Eurostat, own calculations in excel based on HICP (2005=100) – annual data (annual average rate of change).

My observations based on figure 2 are confirmed by tables 1 and 2, which show inflation differentials across member states relative to the EMU-12 average from 1999-2007 and 2008-2013, respectively. It can be seen in table 1 that some member states, such as Ireland, Greece, Spain and Portugal have been characterized by inflation differentials (almost) persistently above the euro area average until 2007 (as of now: group 1). In contrast, other member states such as Belgium, Germany, France, Austria and Finland experienced persistent negative inflation differentials compared to the euro area average in the pre-crisis period (group 2). Lastly, there is a group of countries consisting of Italy, Luxembourg and the Netherlands, for which no clear trend can be established from 1999-2007 (group 3).

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Figure 3: Inflation differentials in the EMU-12 1999-2013.

Group 1

Group 2

Group 3

Source: Eurostat, own calculations in excel based on HICP (2005=100) – annual data (annual average rate of change).

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Figure 3 shows the inflation differentials of each group from 1999-2013. For the purpose of my research, it is especially interesting to note that the trends regarding the 1999-2007 period that I established above, have not continued into the post-crisis years. In group 1, Ireland has shown persistently negative inflation differentials from 2008 onwards. The same applies to Greece after an initial further widening of its positive inflation differential in 2008. Spain’s inflation rates have been fluctuating just above or below the euro area average since the crisis. In group 2, Finland and Austria have shown the biggest reversals, showing persistently positive inflation differentials after the crisis. France, Germany and Belgium all record inflation rates that fluctuate below and above the euro area average. In group 3, Luxembourg mainly experienced positive inflation differentials after the crisis. For the Netherlands and Italy, no clear trend reversals have taken place.

This section has provided a descriptive analysis of inflation differentials in the EMU-12 before and after the 2007 credit crisis. Firstly, it established the magnitude of inflation differentials in the EMU-12 over the years. Secondly, it established that these differentials were rather persistent in the years up to the crisis. Some countries (group 1) were characterized by persistent positive inflation differentials, whereas others (group 2) were experiencing persistent negative inflation differentials. Lastly, this section clearly showed that there have been important reversals in these trends after the 2007. Most notably, the countries in group 1 (Ireland, Greece, Spain and Portugal) are no longer characterized by persistent and large positive inflation differentials. The next section will establish why inflation differentials in a currency union matter.

2.2 Why do inflation differentials matter?

During the first stage towards the creation of the EMU, which started in July 1990, all remaining capital controls between the (future) member states were abolished. The Central Banks of the member states increasingly started to cooperate, but there was no European Central Bank (ECB) yet and exchange rate realignments in response to shocks were still possible. The 1991 Treaty of Maastricht established several convergence criteria in order to make possible the establishment of a common currency in the near future. One of them stated that the average rate of inflation of member states should not exceed the average inflation rate of the three lowest inflation countries in the union by more than 1.5 percent. Member states had to comply with the convergence criteria during the second stage, which started in the beginning of 1994, before being allowed to move on to the third and last stage. The second

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stage also saw the creation of the ECB and the Stability and Growth Pact (which would become binding in the third stage) (Gregoriou et al., 2011). As of the beginning of the third stage in 1999 and hence after the implementation of the Euro, the primary objective of the ECB became price stability, meaning a medium term annual inflation rate of the euro just below two percent. This also meant that member states could no longer conduct independent monetary policy and adjust their nominal exchange rate. The ECB only aims to control euro-area wide inflation, but persistent inflation divergences between member states can be problematic as will become clear in this section (Duarte, 2003).

Optimal currency area. Sufficient similarity in inflation rates is one of the conditions for a

viable currency union according to the Optimal Currency Area (OCA) theory as was first proposed by Mundell in 1961. It is no longer possible to realign exchange rates to correct external imbalances that can develop in case of persistent inflation divergences, as nominal exchange rates are fixed in a currency union (Hofmann and Remsperger, 2005). According to the OCA theory, inflation divergences indicate that a monetary union is characterized by imperfect or incomplete integration (Aldasoro and Žďárek, 2009; Gregoriou et al., 2011). It might be a sign that member states have not really converged during the second stage of the process towards the creation of the EMU (Gregoriou et al., 2011). However, most scholars agree that there are benign and less benign causes of inflation divergences.

Benign causes. As discussed in the introduction, inflation differentials are a natural part of

internal adjustment processes in a monetary union (ECB, 2003). They may reflect differences in real variables such as cross-country initial price level or productivity growth differentials (the latter is the basis for the Balassa-Samuelson effect) (Aldasoro and Žďárek, 2009). The ECB (2003 and 2012) classifies these divergences as part of a ‘catching-up’ process. Andersson et al. (2009) refer to ‘normal’ inflation differentials. In this case, inflation differentials are a normal feature of currency areas as they are part of an equilibrating macroeconomic adjustment, which is necessary because it is no longer possible to adjust nominal exchange rates (ECB, 2005; De Haan, 2010). Inflation differences then reflect a convergence process towards a common price or productivity level (Honohan and Lane, 2003).

Less benign causes. Inflation differentials can also be less benign if they reflect profligacy or

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monetary union can be caused by specific shocks that affect a certain country or region. But they can also be caused by common shocks because of different persistence mechanisms related to national economic structures, different fiscal and wage policies or because of diverging business cycles: profit margins of the private sector could be too high, the fiscal stance of the government could be too lose, wages could be growing too much compared to productivity growth, or there could be a buildup of house and asset price bubbles (ECB, 2003 and 2012). According to Licheron (2007), inflation differentials caused by asymmetric shocks or asymmetric effects of common shocks are more long-term, especially in case of product or labour market imperfections. For example, structural inefficiencies in factor markets can lead to higher production costs and consequently differences in national goods prices. This can harm the relative competitive position of a country as will be discussed in more detail below. In addition, labour market imperfections can cause nominal wage and price rigidities because they hamper national adjustments to (common) shocks (De Haan, 2010). Honohan and Lane (2003) concur as persistence mechanisms such as labour and product market imperfections can cause wage and price stickiness.

Real interest rates and real appreciation. The ECB determines common policy rates based

on euro-area wide inflation rates and output gaps. Hence, diverging inflation rates cause diverging real interest rates which in turn can lead to booms in national credit and housing markets (Moretti, 2014). Put differently, diverging inflation rates can lead to self-reinforcing internal imbalances. Countries with high inflation rates and a booming economy face low real interest rates, further stimulating (overheating) the economy via a boost of investment and consumption. The opposite is true for low growth, low inflation countries (Hofmann and Remsperger, 2005; Aldosoro and Žďárek, 2009; De Haan, 2010). Low real interest rates can make households or businesses build up large debts and they can cause housing or asset price bubbles (Honohan and lane, 2003). In addition, low real interest rates means that governments can borrow funds cheaply which could lead to (fiscal) profligacy (Moretti, 2014).

But there are some counterarguments to the procyclicality issue of the real interest rate channel described above. Firstly, this argument is usually based on ex post measures of the real interest rates (nominal interest rate minus current inflation rate). But it could be argued that investment and consumption decisions are mainly based on ex ante measures of real interest rates (nominal interest rate minus expectations of inflation rates). Divergences in ex ante measures of real interest rates are generally smaller than ex post measures of real

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interest rates (ECB speech, 2005). Secondly, the real exchange rate effect works in the opposite direction compared to the real interest rate effect. In a monetary union, inflation divergences lead to diverging real exchange rates affecting a country’s competitive position (external price competitiveness) (Hofmann and Remsperger, 2005). A country that is characterized by high growth and inflationary pressures will experience a real appreciation of its exchange rate compared to a low inflation country. Hence it will experience a loss of competitiveness and a likely reduction of exports. However, it is not clear whether these two contradicting forces completely offset each other. In addition, a temporary loss of competitiveness can lead to a permanent loss of international market share of a country or reduction in the amount of FDI it receives (due to hysteresis) (Honohan and Lane, 2003; Aldasoro and Žďárek, 2009).

Institutional features. There are some specific institutional features of the EMU, as

compared to for example the United States (this comparison is often made in the literature) that could make inflation differentials particularly large and persistent. The EMU lacks interregional smoothing mechanisms. More specifically, it is characterized by weak migration and labour mobility, labour and product market rigidities, and the absence of a strong federal fiscal transfer system to mitigate potential adverse regional or national consequences of the ECB common monetary policy. In addition, member states can still conduct national fiscal and economic policies (although they are constrained by the Stability and Growth Pact) and countries still have national wage-setting institutions (Honohan and Lane, 2003; ECB speech, 2005; Aldasoro and Žďárek, 2009).

Common monetary policy. Inflation divergences make it more difficult to implement a

common monetary policy. Aldasoro and Žďárek (2009) emphasize potential problems for the ECB’s common monetary policy regarding negative interest rates, repercussions on investment, consumption and the possibility of creating asset bubbles. All of these issues have been discussed already in the section above. Inflation differentials are also important in light of the euro wide optimal target of inflation, which has been set at close to two percent by the ECB. Large and persistent inflation differentials might bring about a debate on the optimal level of this target regarding for example the prevention of deflationary pressures in some countries (Honohan and Lane, 2003). If divergences are only temporary, reflecting convergence processes, this would mean that the ECB will be able to effectively conduct a common monetary policy in the long term. But if they reflect structural imperfections, this

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would make it more difficult to do so without worsening national or regional differences (Gregoriou et al., 2011).

Popular support. Lastly, some scholars emphasize that persistent inflation differentials

could endanger popular support for the EMU as a monetary union because inflation is unpopular and brings certain costs with it related to e.g. real returns on savings and investments and wage negotiations. Potential issues related to persistent inflation differentials will not be solved at a European level as the ECB’s mandate is aimed at safeguarding euro-area wide price stability (Honohan and Lane, 2003; Hofmann and Remsperger, 2005; Aldasoro and Žďárek, 2009; De Haan, 2010).

There is no clear consensus in the literature whether inflation differentials in the EMU are a serious cause for concern or not (De Haan, 2010). This section has established the importance of understanding their determinants. The next section will present an overview of the most important potential determinants of inflation differentials in the EMU that have been discussed in the literature.

2.3 Determinants of inflation differentials

The determinants of inflation differentials in the EMU have been categorized in different ways. Ventura (as noted in Honohan and Lane, 2003) distinguishes explanations related to demand side asymmetric shocks and explanations related to supply side asymmetric shocks, e.g. the Balassa-Samuelson (B-S) effect. Licheron (2007) makes a strong distinction between convergence factors (unavoidable and desirable) and structural factors (more lasting and worrying). The ECB (2012) categorizes potential determinants according to the duration of their effects: longer-term or structural factors, medium-term or business cycle factors, and shorter-term or one-off factors. This paper follows its own categorization. Each category of potential determinants is divided into three parts. The first part establishes how this category of determinants could affect inflation differentials, i.e. through what mechanism. The second part discusses the main results of the existing literature. The last part will establish whether it can be expected that the effect on inflation divergences has changed after the 2007 credit crisis. This is especially relevant for my research.

According to the ECB (2012), the 2007 credit crisis has led to fiscal, financial, and structural reforms in the EMU countries that were characterized by the build-up of large imbalances and inflation differentials. In addition, a large fall in demand and an increase in

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unemployment rates are expected to have reduced inflationary pressures. However, a reduction of EMU inflation differentials might be limited for several reasons. Firstly, downward nominal wage rigidities hamper the adjustment process. Secondly, fiscal consolidation measures during and after the crisis such as indirect tax and administrative price increases have reduced downward inflationary pressures in some countries. Thirdly, not all EMU countries have suffered equally from the crisis and some member states might have continued to experience inflationary pressures in light of historically low nominal interest rates (ECB, 2012).

In short, as will become clear in this section, some macroeconomic and structural factors could have contributed to a reduction of inflation differentials in the EMU after 2007, whereas others might have hampered the necessary adjustment processes (ECB, 2012). The analysis of each category will be followed by a hypothesis about its potentially changing effect on EMU inflation differentials after 2007.

2.3.1 Cyclical factors.

Mechanism. If business cycles of the member states of a currency union are not

synchronized, diverging cyclical movements can contribute to (short-term) inflation differentials through their effect on output growth (Égert et al., 2004; Hofmann and Remsperger, 2005; ECB, 2012). Countries that are characterized by growth above trend6 and/or above the Euro area average growth, experience stronger demand pressures and hence stronger inflationary pressures (Aldasoro and Žďárek, 2009). Cyclical positions can be affected by asymmetric price or demand shocks (i.e. fiscal stance) or asymmetric effects of common shocks (because of different national economic and financial structures) (Hofmann and Remsperger, 2005). The magnitude of cyclically induced inflation differentials can be reinforced via the interest rate channel because national inflation expectations are likely to be affected by national cyclical conditions, which in turn affects the ex ante real interest rate (ECB, 2012). In contrast, the persistence of cyclically induced inflation differentials could be dampened via the real exchange rate channel, as has been explained before (Aldasoro and Žďárek, 2009; ECB, 2012).

Literature. Most papers consider output gap as a potential determinant of inflation

differentials in the EMU. It is used as an indicator of a member state’s phase in the business

                                                                                                                         

6 This is often measured by the output gap: the difference between actual and potential output (Aldasoro and

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cycle. Output gap is considered to be a “proxy for cost pressures over the business cycle” (ECB, 2012: pp.77). Countries that are experiencing GDP above its potential are likely to be characterized by relatively high increases in costs and prices. Honohan and Lane (2003) find that the output gap is not very important as a determinant of EMU inflation divergences. In contrast, Aldasoro and Žďárek (2009) and Andersson et al. (2009) find that it is significant. The ECB (2003 and 2012) analyzes two cyclical factors: business cycle inflation (inflation driven by output) and the real interest rate channel. A large decline in nominal and real interest rates can cause transitory expansionary effects on domestic demand. Égert (2007) finds that output measures, rate of growth of unit labour costs and the consolidated balance of general government as a share of GDP are important determinants of inflation in transition countries. Licheron (2007) is inconclusive because of measurement and causality problems. Regarding measurement, countries with a booming cyclical position might just be characterized by higher trend growth rates (instead of above trend growth). Regarding causality, inflation differentials can be strengthened by the pro-cyclicality of the real interest rate channel. This could make output induced inflation differentials seem larger than they actually are.

After 2007. In general, it can be argued that business cycle synchronization is thought to

increase in a monetary union according to the theory of the endogeneity of OCA criteria. Hence, inflation differentials caused by cyclical factors would then be expected to decrease over time within the EMU (Égert et al., 2004). But this line of reasoning does not specifically account for the effects of the crisis on inflation divergences. The ECB does. It argues that diverging business cycles could have played a role in causing inflation differentials before the crisis. Countries that were experiencing a boom such as Greece, Spain and Luxembourg were characterized by positive inflation differentials, whereas countries with negative output gaps such as Germany, the Netherlands and Austria were experiencing low or even negative inflation differentials (ECB, 2012).

Diverging business cycles were (partly) caused by low risk premia7 for countries that were characterized by interest rates and inflation rates way above the euro area average up until the creation of the EMU. These low risk premia could reflect lower financial costs and integrated capital markets, but according to the ECB it was largely due to the widespread belief that the Maastricht convergence criteria had equalized country risks across the currency

                                                                                                                         

7 Risk premia are measured as the spread between ten-year government bond yields and German ten-year bonds

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union. Countries that were characterized by risk premia far below their long-term trend, such as Greece, Ireland, Portugal and to a lesser degree Spain, were also experiencing economic booms and positive inflation differentials in the pre-2008 period (ECB, 2012).

This changed abruptly in 2008. Countries that were characterized by very low ex ante real interest rates before the crisis, such as Greece and Portugal, were experiencing severely higher real ex ante lending rates after the beginning of the crisis. This reduces credit growth and domestic demand. Hence, these countries were also experiencing negative output gaps. In addition, they have implemented fiscal policies such as reductions of public sector wages which affect cyclical movements (ECB, 2012).

Hypothesis 1: Cyclical factors are expected to be a less important determinant of EMU

inflation differentials in the 2008-2013 period compared to the 1999-2007 period.

2.3.2 Convergence effects

Mechanism. Convergence among EMU member states can cause inflation divergences in

several ways. Firstly, convergence of real and nominal interest rates and integration of the European capital market could lead to an increase in aggregate demand in countries that faced high interest rates before accession to the EMU. This can cause prices to increase, especially in the non-tradable (services) sector (Fendel and Frenkel, 2009).

Secondly, the creation of the Single European market and the implementation of a common currency have led to a reduction in price level dispersion, especially in the tradables sector. The convergence of price levels among member states can contribute to inflation differentials, in particular in the first years of the currency union (Fendel and Frenkel, 2009). Convergence of tradable goods prices depends on the (enforcement of) Single Market legislation, national regulations that might hamper trade, and the amount of competition on a national and European level (ECB, 2003). EMU trade integration and the establishment of a common currency have led to more price transparency, less transaction costs and the abolishment of exchange rate uncertainty (Hofmann and Remsperger, 2005). These developments are expected to lower deviations from the law of one price (Égert et al., 2004; De Haan, 2010). Euro countries that are characterized by relatively low prices of tradable goods will experience higher demand than countries that produce more expensive substitutes, causing prices in the initially low price country to rise faster than in the high price country, hence causing inflation differentials via this international competitiveness mechanism (ECB, 2012).

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Thirdly, the B-S effect can contribute to inflation differentials (Fendel and Frenkel, 2009). Non-tradable goods prices are expected to converge because of real income convergence. This happens via the so-called B-S effect. New member states or countries that lag behind in development compared to other EMU states are likely to experience relatively high productivity growth levels, especially in the tradable goods sector as it is more capital intensive and because it experiences more competition in the integrated European market. This productivity growth is associated with wage increases in the tradable sector (until wage equals marginal product of labour). Assuming domestic labour mobility between the tradable and non-tradable sector, nominal wages in the latter sector will increase as well. This means that prices in the non-tradable sector must rise in order to prevent real wage growth out of line with labour productivity growth. Hence, countries that are characterized by relatively high levels of productivity growth in light of real income convergence are likely to face relatively high levels of goods prices inflation, as inflation rates are based on both traded and non-traded goods prices (Hofmann and Remsperger, 2005).

Literature. Honohan and Lane (2003) find that the B-S productivity growth effect has not

played an important role in explaining EMU inflation differentials (1999-2001), but it could in the future for accession countries. Price level convergence is significant. The ECB (2003) is inconclusive about the effects of tradable goods price convergence (due to the European single market) and non-tradable goods price convergence (B-S effect). Égert (2007) finds no importance of the B-S effect or of changes in final household consumption due to economic catching up. Aldasoro and Žďárek (2009) do not look at the B-S effect, but find that price level convergence is important. According to Licheron (2007), price convergence and the B-S effect are small. In sum, as De Haan (2010) concludes, evidence on convergence is mixed. Scholars have tried to come up with possible explanations for the lack of B-S effect that has been found in research. It could be, for example, due to the low share of services in the Consumer Price Index (CPI) in countries that are catching up.8 In addition, the assumption of

labour flexibility, which plays an essential role in the equalization of wages across tradable and non-tradable sectors, might not hold in practice (Égert et al., 2004).

                                                                                                                         

8 The non-tradables sector is assumed to largely consist of services. If a country is characterized by a low share

of services in its CPI, this would mean that an increase in wages and prices in this sector as a result of productivity growth in the tradable sector (which forms the basis of the B-S effect) does not lead to a large rise in inflation rates.

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After 2007. Convergence of price levels is likely to become less important over the years

(ECB, 2012). Price level convergence for non-tradable goods, also known as the B-S effect, should become less important as the process of catching up of member states has progressed (Égert et al., 2004).

Hypothesis 2: Convergence effects are expected to be a less important determinant of EMU

inflation differentials in the 2008-2013 period compared to the 1999-2007 period.

2.3.3 External factors9

Mechanism. Changes in the nominal exchange rate affect import prices. This is also known

as exchange rate pass-through. Changes in import prices then affect domestic tradable goods prices and consequently other prices and national inflation rates (Égert et al., 2004). The magnitude of pass-through and the way it affects EMU inflation differentials is determined by several factors. Firstly, member states are characterized by different extra-EMU openness to trade. This means that changes in exchange rates affecting import prices can have a differential impact on the inflation rates in member states. The more a member state is engaged in trade with extra-EMU countries, the more sensitive it will be to changes in exchange rates. Secondly, differences in the composition of imports can contribute to inflation differentials (Angeloni and Ehrmann, 2004). This is related to for example the share of imported intermediate and final goods in manufactured goods that are produced domestically (Égert et al., 2004). Thirdly, geographical trade structure could be an additional determinant of the pattern and degree of pass-through and hence inflation divergences. A member state that mainly trades with extra-EMU countries whose exchange rates are relatively stable against the euro would be mildly impacted in terms of changes of domestic prices by a period of appreciation or depreciation of the euro (ECB, 2003). Lastly, expectations regarding the duration of exchange rate changes are important for the degree of pass-through (Égert, 2007).

Literature. Honohan and Lane (2003) came up with a new hypothesis, establishing that the

creation of the Eurozone itself (besides having reduced inflation rates in the years up to the currency union) is also causing inflation divergences by different exposures to extra-EU trade. In order to test this hypothesis, they consider the differential effect of the nominal

                                                                                                                         

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effective exchange rate (NEER10) and find that it is significant for inflation differentials.

Countries that experienced a depreciation of the NEER larger than the European average also experienced relative higher inflation rates. Honohan and Lane (2003) argue that this could be a temporary effect because of the decline of the euro from 1999-2001 and because trade patterns evolve (more intra-euro zone trade is to be expected). Many scholars have subsequently considered external effects (some also including e.g. oil prices and energy intensity) as an explanation of inflation differentials in EMU. Égert (2007) finds that the NEER plays a prominent (but declining) role in transition countries. According to the ECB (2003) and Licheron (2007), the NEER and oil price shocks are important sources of inflation differentials. In contrast, Andersson et al. (2009) and Aldasoro and Žďárek (2009) find almost no significance for external factors. According to the latter papers, exchange rate movements have become a less important explanation of inflation differentials 10 years after the introduction of the euro.

After 2007. Assuming that the EMU causes increasing intra-union trade, it is expected that

the role of exchange rate changes in explaining inflation differentials will be reduced (Égert et al., 2004; Andersson et al, 2009; Aldasoro and Žďárek, 2009).

Hypothesis 3: The importance of external factors in explaining EMU inflation differentials is

expected to have declined in the 2008-2013 period compared to the 1999-2007 period.

2.3.4 Market rigidities – labour market flexibility

Mechanism. As was already established in the introduction, labour market flexibility plays

an essential role in the process of ‘internal devaluation’ in a monetary union (Zemanek, 2010). However, a lack of labour market flexibility can cause downward wage and price rigidity, which could be a determinant of inflation differentials. More specifically, labour and product market characteristics can affect inflation differentials through the dynamics of real wages and marginal costs of firms (Jaumotte and Morsy, 2012). Structural inefficiencies in labour markets can lead to diverging production costs and hence diverging prices (De Haan, 2010). Rigidities associated with different wage-setting mechanisms (e.g. indexation of

                                                                                                                         

10 The NEER is a measure of the exchange rate of the domestic currency versus other currencies (in this case the

domestic currency of all countries in the analysis is the Euro), but weighted by the share of these currencies in the country’s international trade or payments (OECD Economic Outlook).

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wages to prices) or different price-setting mechanisms (e.g. diverging frequency of price changes) can hamper national adjustments to demand pressures (Licheron, 2007).

It was expected that the creation of the EMU would increase incentives for structural reform of national labour market institutions as labour market flexibility increases the ability to absorb shocks. This becomes increasingly important in a monetary union because countries give up the ability to pursue independent monetary policy. In addition, a more efficient labour market could reduce the natural rate of unemployment. But reforms are associated with great political costs, as it concerns reductions in unemployment benefits, the level of minimum wages and unemployment protection. Moreover, it could also be argued that the creation of the EMU has reduced incentives to reform national labour markets as the establishment of the ECB, with its independent policies focused on price stability, has led to a lower inflation bias (De Haan, 2010). In short, it is clear that labour market flexibility could play a role in explaining inflation differentials in the EMU. But based on theory, it is not clear whether labour market flexibility has actually increased since the start of the EMU and hence to what extent it has affected EMU inflation divergences in practice.

Literature. There is only a limited amount of literature that empirically analyzes the role of

labour and product market institutions in explaining inflation differentials in the EMU. Andersson et. (2009) include product market regulation in their regression, but they do not take into account labour market flexibility. Other scholars, such as Campolmi and Faia (2006), examine the impact of labour and product market institutions on inflation divergences by calibrated models with microeconomic foundations (as noted in Jaumotte and Morsy, 2012). Moreover, there is some literature that analyzes the influence of these institutions on the persistence of inflation differentials. Correa-Lopez et al. (2010) and Biroli et al. (2010) find mixed results (as noted in Jaumotte and Morsy, 2012). Jaumotte and Morsy (2012) conclude that labour market rigidities increase the persistence of differentials, as well as the impact of shocks. In addition, they argue that countries that experience high inflation rates are likely to be characterized by high employment protection and intermediate coordination of collective wage bargaining. Hence, labour market characteristics have played a significant role in the build-up of high and persistent inflation differentials in the years prior to the crisis. They have also hampered the downward adjustment of inflation rates in these countries during the crisis and worsened the inflation-output trade-off. However, none of these studies (including Jaumotte and Morsy, 2012) take into account the role of labour market regulations

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in explaining EMU inflation divergences in the years after the crisis. This will be an important extension of my research.

After 2007. According to the ECB (2012), structural reforms of the labour and product

markets in Germany and Austria in the pre-crisis period contributed to negative inflation differentials in these countries, whereas a lack thereof in Greece, Portugal and Spain contributed to high inflationary pressures. In addition, countries like Belgium, Spain and Luxembourg were characterized by real wage rigidities, increasing the likelihood of persistent inflation differentials (ECB, 2012). This trend has been reversed after the crisis. The asymmetric effects of the 2007 crisis on national public finances, financial sectors and real economies in the EMU and the associated build-up of external imbalances highlighted the importance of labour market reforms in order to smooth adjustments of shocks in the currency union (Turrini et al., 2014). Structural reforms can help the peripheral countries to regain competitiveness (Moretti, 2014). However, the effect on EMU inflation differentials depends on the symmetry of reforms across the euro area (ECB, 2003).

The GIIPS11 countries that were characterized by relatively high inflation rates prior to the crisis and hence by significant losses in their competitive position, have been trying to increase product and labour market flexibility in recent years. The ECB argues that this has been especially successful with respect to the labour market, increasing downward wage flexibility in some countries (although they do not specify which countries) (ECB, 2012).12

These results are confirmed by two researches conducted under auspices of the European Commission. The EC (2014) established that the Southern and Eastern European countries have implemented extensive reforms in employment protection legislation (EPL) since 2008. Moreover, countries that were characterized by the build-up of large imbalances and heavy regulation before the crisis, in particular Spain and Italy, have continued to implement EPL reforms in recent years. Other EMU countries have implemented labour market reforms as well, albeit to a lesser extent. Within the EMU-12, the OECD13 EPL indicator has gone down

especially for Portugal, and to a lesser extent for Greece, Spain and Italy (EC, 2014).

                                                                                                                         

11 Greece, Italy, Ireland, Portugal and Spain.

12 The ECB is more critical on the achievements in reforming the non-tradable sector, mainly referring to the

excessive profits margins in the domestic sector, i.e. services, due to limited competition. This prevents downward price adjustments. Nevertheless, there have been some attempts to improve competitiveness such as reductions in public sector wages (ECB, 2012).

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Turrini et al. (2014) analyze labour market reforms in the EMU using a different database (LABREF database)14. They establish several trends in the post-2008 EMU labour market reforms. Firstly, the crisis mainly led to reforms in EPL, unemployment benefits and wage-setting mechanisms. Secondly, countries with similar institutional structures implemented similar reforms. Broadly speaking, countries that were characterized by inefficient and overregulated labour markets before the crisis carried out the most far-reaching reforms. Thirdly, although all countries implemented labour market reforms in the heat of the crisis in order to mitigate its immediate negative effects, there was a second wave of more structural reforms (related to e.g. job protection) starting in 2010 in especially the Southern European countries and (to a lesser extent) the Eastern European countries. These reforms were necessary to enable labour markets to adjust faster to shocks as (especially) the Southern and Eastern European countries were dealing with prolonged and severe reductions in aggregate demand, current account reversals and debt crises (Turrini et al., 2014).

Hypothesis 4: Structural reforms that have been implemented since the crisis are likely to

have reduced market rigidities. Hence, the role of market rigidities in explaining EMU inflation differentials is expected to have declined in the 2008-2013 period compared to the 1999-2007 period.

2.4 Sub-conclusion

This chapter has provided a descriptive and theoretical analysis of inflation differentials. The descriptive section has established the magnitude and pattern of inflation differentials in the EMU since 1999. More specifically, it has shown that there have been important trend reversals after the 2007 credit crisis. In addition, the theoretical section has established why, depending on its determinants, inflation differentials could be worrying for the EMU. Moreover, it provided an overview of the most important determinants of inflation divergences that have been discussed in the literature so far. The next chapter will perform an empirical analysis on the determinants of inflation divergences in the EMU-12 from 1999-2007 and from 2008-2013. This will be done by combining the approaches of Honohan and Lane (2003) and Licheron (2007), using a dynamic panel regression model to be estimated by system-GMM (also known as the Blundell and Bond estimator). The chapter will introduce

                                                                                                                         

14The LABREF database was set up by the European Commission’s Directorate General for Economic and

Financial Affairs (DG ECFIN) and the Economic Policy Committee of the ECOFIN Council (as found in Turrini et al., 2014).

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the variables that are used in the regression (based on the four categories of determinants as discussed in 2.3), describe the data, the method and analyze the results.

3. Empirical analysis

This chapter will perform an empirical analysis on the determinants of inflation divergences in the EMU-12 from 1999-2007 and from 2008-2013. The first section consists of a description of the data. The second section will describe the method used for the empirical analysis. Finally, the results will be discussed.

3.1 Data

This section consists of a description of the data that are used in the empirical analysis. It establishes how the dependent and independent variables are measured and what databases were used.

3.1.1 Dependent variable

The annual inflation rate (𝜋!,!) will be measured by the annual growth rate of the Eurostat

all-items HICP (Harmonized Index of Consumer Prices). This is the official index of the ECB, who defines price stability on the basis of the annual rate of change of the euro area HICP. HICP’s can be used for the comparison of national consumer price inflation. They have a common index reference period (2005 = 100).

3.1.2 Independent variables

This section introduces the independent variables that will be used in the regression, based on the four categories of determinants as discussed in 2.3.

Cyclical factors. Cyclically-induced inflation differentials will be captured by the output gap

(𝐺𝐴𝑃!,!) and by the fiscal stance (𝐹𝐼𝑆𝐶!,!). Data on the output gap are available in the OECD Economic Outlook Database, but Luxembourg is missing (it does not state the reason). Therefore I use the AMECO15 database of the European Commission for this variable. It measures the gap between actual and potential GDP as a percentage of potential GDP at 2010 reference levels. The sign of the coefficient is expected to be positive, as countries that are

                                                                                                                         

15AMECO is the annual macro-economic database of the European Commission’s Directorate General for

Economic and Financial Affairs (DG ECFIN, as found on the EC website).  

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characterized by growth above potential are likely to experience stronger inflationary pressures. As a robustness check, I will use the Hodrick-Prescott filter (with a smoothing parameter of 30) to obtain the output gap from the AMECO GDP deflator. This filter removes the cyclical component of a time series.

In addition, I will consider the fiscal stance (𝐹𝐼𝑆𝐶!,!) as a potential determinant of cyclically-induced inflation differentials. The fiscal stance will be measured by the government primary balance as a percentage of GDP, as can be found in the OECD Economic Outlook database. It is available for all countries in the analysis at an annual basis. A primary deficit will increase aggregate demand and is likely to cause inflationary pressures. Hence, I expect the sign of the coefficient to be negative.

Convergence effects. This thesis takes into account two convergence effects that could

attribute to inflation differentials. Firstly, price level convergence will be captured by the lagged price level (𝑃!,!!!). Honohan and Lane (2003) use the price level as measured by the consumption price level in the Penn World Tables. Unfortunately, the most recent version of these tables only covers price levels up until 2010. Therefore, following i.e. Licheron (2007), I use the lagged PPP factor calculated by the OECD variable (purchasing power parities, total, national currency units/US dollar) as a proxy for price level convergence. This variable is available on an annual basis. I expect the coefficient of 𝑃!,!!! to be negative, as lower initial price levels are associated with higher inflation rates due to nominal convergence in a monetary union. One could also consider the Eurostat Final Consumption Aggregates/Expenditures as a proxy for price level convergence (as was done by e.g. Aldasoro and Žďárek, 2009). However, Eurostat data on some countries (for example, Austria) are missing. As a robustness check, following Andersson et al. (2009), I consider the lagged comparative price level indices based on actual individual consumption by Eurostat (expressed relative to the euro area).

Secondly, the Balassa-Samuelson effect will be captured by the annual labour productivity growth rate of the non-agriculture business sector (𝑃𝑟𝑜𝑑_𝐺𝑟𝑜𝑤𝑡ℎ!,!). This variable is taken from the OECD Economic Outlook Database. It measures the gross value added per hour worked (constant prices) and is available on an annual basis. This is expected to be a good proxy for the B-S effect when assuming, following Licheron (2007) and the B-S theory in general, that productivity growth rates in the non-tradable sector are similar across the EMU-12 countries. Hence, productivity growth differentials of the business sector then

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(mainly) represent tradable sector productivity growth differentials. I expect the coefficient of 𝑃𝑟𝑜𝑑_𝐺𝑟𝑜𝑤𝑡ℎ!,! to be positive as countries with a high productivity growth due to the B-S

effect are expected to experience inflationary pressures. Other scholars, such as Andersson et al. (2009), have obtained labour productivity data from Eurostat. But there are quite some missing values for Ireland, Luxembourg and Greece.

External factors. Following Honohan and Lane (2003) and Andersson et al. (2009), this

thesis uses the change of the nominal effective exchange rate (∆𝑁𝐸𝐸𝑅!,!) as an indicator for the exposure to exchange rate fluctuations. The NEER is a measure of the exchange rate of the domestic currency versus other currencies (in this case the domestic currency of all countries in the analysis is the Euro)16, but weighted by the share of these currencies in the country’s international trade or payments (definition taken from OECD Economic Outlook). The NEER is taken from the IMF International Financial Statistics Database.17 It is based on the Consumer Price Index (base 2010=100) and available on a quarterly and annual basis. There are no missing values. A rise of the nominal effective exchange rate means that it has appreciated. I expect the coefficient of ∆𝑁𝐸𝐸𝑅!,! to be negative, meaning that countries that are characterized by a depreciation of the NEER larger than the European average experience relatively higher inflation rates.

Market rigidities. As explained before, this thesis focuses on the role of (a lack of) labour

market flexibility in causing market rigidities and consequently inflation divergences in the EMU-12. Labour market flexibility will be captured by the change in the average Employment Protection Legislation indices of the OECD (∆𝐸𝑃𝐿!,!), which have been used by, for example, Moretti (2014) to explain inflation differentials. These indices measure the procedures and costs involved in the dismissals of individuals or groups of workers for both regular and temporary contracts (OECD website). EPL is an index with values from 0 to 6, reflecting the level of regulation. I expect the coefficient of the change in average EPL to be positive as an increase in employment protection legislation relative to the euro area is likely to be associated with a low level of labour market flexibility, hence leading to market rigidities and higher inflation rates. The OECD EPL indices are available on an annual basis up until 2013. There are no values for Luxembourg in the pre-crisis period. Alternatively, one

                                                                                                                          16 Except for Greece in 1999 and 2000.

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could consider using EPL measures from the LABREF Database. This database provides more detailed information on EU member states’ labour market policies. But at the moment, it only covers the 2000-2011 period. The 2007 credit crisis is likely to have acted as a catalyst for change in the area of EPL. Hence, using the change in EPL as an indicator for market rigidities could provide interesting results in analyzing the determinants of inflation differentials before and after the crisis.

 

Overview. Table 3 provides an overview of the explanatory variables used in the empirical

analysis and their expected effect on EMU-12 inflation differentials. The next section will establish the empirical model of this thesis.

Table 3: Determinants of inflation differentials.

Explanatory variables Expected sign coefficient (effect on inflation differentials)

Cyclical factors Output gap +

Fiscal stance -

Convergence effects Initial price level -

Balassa-Samuelson effect +

External factors NEER -

Market rigidities EPL +

3.2 Empirical method

This thesis establishes the relative contributions of the main determinants of inflation differentials that have been put forward in the literature, plus a proxy for labour market flexibility. It will do so by combining the methodologies of Honohan and Lane (2003) and Licheron (2007). The latter builds upon the model of the former, but introduces some alterations and extensions. This section will explain their empirical methods and model choices step by step.

A general specification for inflation differentials in the EMU-12 could look as follows:

𝜋!,! − 𝜋!! =∝!+ 𝛽 𝑋!,!− 𝑋!! + 𝛿 𝑃!,!!!− 𝑃!,!!!∗ − 𝑃!!!! − 𝑃!!!!∗ + 𝜀!,! (1)

The first variable on the left side of the equation is the annual national inflation rate and the second one is the EMU-12 inflation rate. On the right side, ∝! represents unobserved country-specific effects. Country-fixed effects are not included by Honohan and Lane (2003), as they argue that it is unlikely that there are permanent inflation differentials across the EMU-12

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