Inflation Persistence Differentials among Euro Area Countries

Abstract

The inflation differentials problem has been prominent in European economic debates. Since the ECB's monetary policy is directed at inflation rates in the euro area as a whole, persistent inflation differentials among euro area countries would cause the persistent real interest rate differentials. A popular argument claims that a unified monetary policy may be excessively tight for lower inflation countries and loose for higher inflation countries, and then, which would increase economic divergence among euro area countries. One of the sources of the persistent inflation differentials is the differences in degree of inflation persistence. In this paper, we will focus on the inflation persistence as the source of inflation differentials and we will estimate the degree of inflation persistence in lower inflation countries and higher inflation countries. We introduce a closed economy DSGE model and estimate it using Bayesian estimation methods. We will show that intrinsic persistence is moderate and the differences in degree of intrinsic persistence are small between both groups. The degree of differences in expectation-based persistence is also small between both groups, which means that the frequency of firm's price adjustment is uniform across the euro area countries. On the other hand, extrinsic persistence is higher in lower inflation countries, while lower in higher inflation countries. It means that that inflation rates would rise higher in lower inflation countries, where GDP gap would be small due to the tight monetary policy, while inflation rates would rise lower in higher inflation countries, where GDP gap would be large due to the loose monetary policy. These adjustment mechanisms would eventually drive inflation differentials back to equilibrium. The impulse response functions analysis shows that the unified monetary policy would have similar effects among the euro area countries. From these results, we can conclude that intrinsic and extrinsic persistence in inflation rates are not the source of inflation differentials and it would not hamper the symmetric transmission of single monetary policy.