## _wp06154

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---

### Maastricht inflation criterion and historical role
- Maastricht inflation criterion: inflation of no more than 1½ percent above the average inflation rate of the three European Union (EU) member states with the most stable prices.
- Purpose: encourage pre-EMU structural reforms and convergence of inflation prior to the introduction of the euro.
- Historical outcomes:
  - Differential between high- and low-inflation countries fell from about 4 percent to less than 2 percent by 1997.
  - Average inflation around “close to but below 2 percent” during the early 2000s.
  - Post-entry acceleration of inflation occurred in several countries despite the criterion.

### Empirical links between inflation and its drivers (EU-15, 1996–2005)
- Regression/GMM findings:
  - A 1 percent output gap has been associated with a reduction in annual inflation of about 0.3–0.4 percent.
  - More regulation in product or labor markets by one sample standard deviation has been associated with a rise in inflation, by 0.3–1.0 percent.
  - Panel GMM: EU-15 inflation associated mostly with variability of the output gap and structural reform variables; price-level convergence not statistically significant but omission generates omitted-variable bias.
- Quantitative table highlights (specifications A–D, dependent variable: annual inflation; observations: 140):
  - GDP per capita coefficients: -1.835 (1.22), -1.121 (0.91), -1.126 (0.77), -1.498 (0.92).
  - Output gap coefficients: 0.429** (5.53), 0.409** (5.44), 0.337** (4.49), 0.374** (4.80).
  - Product market regulation (specification A): 1.91** (3.81).
  - Administrative regulation (specification B): 0.237 (1.57).
  - Labor market regulation (specification C): 0.671* (2.09).
  - Index of regulation (specification D): 0.980* (2.41).
  - R-squared values: 0.70, 0.66, 0.68, 0.68.
  - Note: * significant at 5 percent; ** significant at 1 percent.

### Sinners and saints; compliance and cyclical context
- Post-euro (1999–2005) pattern:
  - The three highest-inflation eurozone countries averaged 1 percentage point higher than the level implied for ERM2 members by the Maastricht criterion.
  - On average, one in five EU-15 countries recorded inflation at least 50 basis points above the Maastricht criterion in a given year.
  - Among new member countries (NMCs), the three highest-inflation NMCs missed the inflation criterion on average by 3.5 percentage points.
- Typical frequent “sinners”:
  - EU-15: Greece, Ireland, Spain.
  - NMCs: Estonia, Hungary, Latvia, Slovakia, Slovenia.
- Observation on “saints”: low inflation among saints frequently coincided with substantial negative output gaps (GDP below potential).

### Price dispersion, optimal currency area considerations, and risks
- Euro-area average inflation masks cross-country dispersion; ECB faces noise from divergent national inflation and cyclical conditions.
- Limited nonmonetary equilibrating mechanisms (capital and labor mobility) increase reliance on relative price and wage adjustments.
- Countries with persistently higher inflation risk long-term competitiveness losses unless offset by productivity growth.

### Disinflation strategies and trade-offs
- Two broad strategies:
  - Fiat disinflation (“low inflation now, reforms later”):
    - Tools: short-term demand stabilization, administrative measures, changes in regulated prices, indirect tax changes, temporary wage freezes.
    - Short-term: modest costs aided by “borrowed credibility” from the ECB.
    - Long-term: high costs due to structural rigidities and a flatter Phillips curve; future disinflations become more costly and monetary transmission weaker.
  - Reformist strategy:
    - Market-oriented structural reforms and credible monetary policy to lower inflation permanently via expectations and flexible markets.
    - Outcome: lower long-term disinflation costs due to more efficient monetary transmission and forward-looking agents.
- Incentive effects of the criterion:
  - A tight one-year inflation criterion increases incentives for fiat measures to meet euro-entry dates.
  - A softer or cycle-adjusted criterion would reduce incentives for short-term administrative measures and favor reform.

### Model framework (aggregate open-economy specifications)
- Aggregate demand (open-economy IS): y_t = a1 y_{t-1} + a2 r_{t-1} + a3 q_{t-1} + u_t.
- Aggregate supply (Phillips curve): π_t = b1 π_{t-1} + b2 π^E_{t+1} + γ y_{t-1} + b1^imp π^{imp}_t + η_t.
- Expectations formation: π^e_{t+1} = (1−λ) π^e_t + λ π_t + ε^e_t.
- Uncovered interest parity / exchange rate: Δs_{t+1} = (1−c1)(ir_t − ir^*_t − prem_t) + c1 Δs_t + ν_t.
- Monetary policy (Taylor rule): i_t = d1 i_{t-1} + d2 (π^e_{t+1} − π_T) + d3 y_t + ε_t, with d2 = ½ and d3 = ½ for comparability; d1 country-specific.
- Disinflation drivers: negative output gap required; slope γ of Phillips curve determines sensitivity; forward-looking agents (small b2) and low exchange-rate persistence (small c1) reduce disinflation costs.

### Calibration (countries and key parameter values)
- Countries calibrated: Greece, Ireland, Italy, Spain (EU-15 high-inflation cases); Czech Republic, Hungary, Poland, Slovakia, Slovenia (NMCs).
- Main country-specific coefficients (columns: Output persistence a1 | Expectations formation a2 | The slope of the supply curve γ | Exchange rate persistence c1 | Taylor rule policy persistence d1):
  - Greece: 0.60 | 0.40 | 0.20 | 0.90 | 0.40
  - Ireland: 0.80 | 0.70 | 0.20 | 0.30 | 0.40
  - Italy: 0.90 | 0.60 | 0.05 | 0.40 | 0.50
  - Spain: 0.90 | 0.90 | 0.10 | 0.50 | 0.60
  - The Czech Republic: 0.80 | 0.50 | 0.20 | 0.20 | 0.50
  - Hungary: 0.90 | 0.50 | 0.05 | 0.50 | 0.90
  - Poland: 0.90 | 0.80 | 0.30 | 0.50 | 0.40
  - Slovakia: 0.90 | 0.50 | 0.10 | 0.90 | 0.50
  - Slovenia: 0.90 | 0.70 | 0.20 | 0.90 | 0.50
- Country characteristics noted:
  - Reform laggards tend to have flatter Phillips curves (Hungary, Italy).
  - Countries with credible monetary policies show more forward-looking agent behavior (the Czech Republic, Ireland).

### Simulation design and scenarios
- First set: monetary authority announces credible lower inflation target equivalent to the Maastricht criterion; authorities choose least-cost disinflation path given reaction function. Disinflations start six quarters before the country last had inflation at or below the criterion (or six quarters before end of data sample if not yet meeting the criterion). Five-year disinflation trajectories and cumulative output gaps are model-dependent.
- Second set: normalize disinflation shock to 100 basis points for all countries; cumulative output gap calculated over three-year horizon (12 quarters) and full simulation horizon.

### Key quantitative simulation results (exact reported figures)
- Average required disinflation for EU-15 sample: 90 basis points.
- Country-specific estimates (five-year sacrifices where reported):
  - Ireland: disinflation of 170 basis points would require sacrificing about ½ percent of GDP during the next five years.
  - Hungary: disinflation of 300 basis points would require sacrificing 7 percent of GDP during the next five years.
  - Slovakia: disinflation of 600 basis points would require sacrificing 12 percent of GDP during the next five years.
  - Czech Republic: relatively small output loss of ¾ percent of GDP.
  - Poland: relatively small output loss of ¾ percent of GDP.
  - Slovenia: output loss of 3 percent of GDP.
- Country-specific disinflation start and target inflation (from simulation figures):
  - Greece: disinflation from 3.2 percent to 2.6 percent.
  - Ireland: disinflation from 4.6 percent to 2.9 percent.
  - Spain: disinflation from 3.0 percent to 2.6 percent.
  - The Czech Republic: disinflation from 3.9 percent to 2.7 percent.
  - Hungary: disinflation from 5.5 percent to 2.6 percent.
  - Poland: disinflation from 3.1 percent to 2.0 percent.
  - Slovakia: disinflation from 8.6 percent to 2.7 percent.
  - Slovenia: disinflation from 5.2 percent to 2.7 percent.
- Cross-country and horizon patterns:
  - Disinflation not very costly in the Czech Republic, Ireland, and Poland.
  - Very costly in Hungary and Italy; marginally smaller costs in Slovenia and Spain.
  - Three-year and full-horizon losses similar in the Czech Republic, Ireland, Poland, and Slovakia.
  - Long-run losses are multiples of short-run losses in Greece, Hungary, Italy, Slovenia, and Spain.
  - Differences attributed to exchange rate pass-through speed and interest-rate sensitivity of the exchange rate.
- Role of credibility:
  - Large output losses in Hungary attributed to limited credibility of national monetary policy (unable to bring inflation systematically below 5 percent since 1990; disinflation from double-digits only in 2001).
  - Eurozone country results reflect structural characteristics given common monetary policy.

### Policy implications and explicit recommendations
- General consequences:
  - Maastricht criterion helped promote a public stance toward low inflation but biased strategy choice toward short-term fiat measures in some countries.
  - Fiat measures are politically less costly short-term but postpone structural reforms, preserving high sacrifice ratios and making future disinflations costly.
  - Rush toward low inflation driven by fiat measures would be costly for NMCs and the ECB: stalled reforms, inflexible economies, real exchange rate appreciation after euro adoption, and a worsened eurozone transmission mechanism complicating ECB decision making.
- Two specific recommended changes to the Maastricht inflation criterion:
  - Exclude economies with large negative output gaps from the calculation of the Maastricht inflation criterion, or calculate the average inflation rate over the full length of the business cycle (output gap estimates are published by the EU AMECO database).
  - Lengthen the testing period (currently 12 months during ERM2) to cover the full business cycle to reduce incentives for fiat disinflation strategies.
- Additional observations:
  - A tight definition and short testing period may tilt NMCs toward fiat-measure strategies; a softer criterion and longer testing period would favor long-run reform strategies.
  - Some countries may still prefer fiat measures if they expect immediate gains from the euro or face political incentives (e.g., elections), or if ECB credibility makes agents more forward-looking.
  - Benefits of lower interest rates from euro entry are not relevant for most NMCs given their public-debt-to-GDP ratios are one-half or less compared with those of Greece and Italy in the 1990s.

### Conclusions (summary findings)
- The Maastricht inflation criterion helped reduce inflation dispersion among EU countries to levels last seen in the 1960s but may bias disinflation strategy choices toward fiat measures in countries that stand to gain from euro entry.
- Simulations using a simple macroeconomic model calibrated to nine countries find:
  - Implied sacrifice ratios differ across countries and across horizons, conditional on coefficient stability.
  - Differences arise from national Phillips curve slopes, expectations formation, and persistence of output, inflation, and exchange rates.
- Policy changes suggested:
  - Calculate the Maastricht criterion to avoid business-cycle influence (exclude countries with negative output gaps or use full business-cycle averaging).
  - Lengthen the criterion evaluation period to avoid reliance on fiat disinflation strategies.

*Source: IMF Working Paper chapter "_wp06154" (excerpt).*

### 1.     EU Inflation Sinners ............................................................................................

### EU Inflation Sinners

### Maastricht inflation criterion and historical role
- Maastricht inflation criterion: inflation of no more than 1½ percent above the average inflation rate of the three European Union (EU) member states with the most stable prices.
- Purpose: encourage pre-EMU structural reforms and convergence of inflation prior to the introduction of the euro.
- Result: the criterion motivated all-European inflation convergence in the late 1990s, but did not prevent post-entry acceleration of inflation in several countries.
- Secular context: the differential between high- and low-inflation countries fell from about 4 percent to less than 2 percent by 1997; average inflation around “close to but below 2 percent” during the early 2000s.

### Empirical links between inflation and its drivers
- Regression/estimation findings (EU-15, 1996–2005):
  - A 1 percent output gap has been associated with a reduction in annual inflation of about 0.3–0.4 percent.
  - More regulation in product or labor markets by one sample standard deviation has been associated with a rise in inflation, by 0.3–1.0 percent.
- Panel GMM results: EU-15 inflation during 1996–2005 is associated mostly with variability of the output gap and structural reform variables; price-level convergence was not statistically significant but its omission generates omitted-variable bias.
- Interpretation: lack of structural reforms can push inflation up via cost-push channels (markup or wage-cost pressures) and by making inflation more persistent through impaired monetary transmission.

### Sinners and saints: compliance and cyclical context
- Post-euro experience: in 1999–2005 the three highest-inflation eurozone countries averaged 1 percentage point higher than the level implied for ERM2 members by the Maastricht criterion.
- Frequency of noncompliance:
  - On average, one in five EU-15 countries recorded inflation at least 50 basis points above the Maastricht criterion in a given year.
  - Among new member countries (NMCs), the three highest-inflation NMCs have been missing the inflation criterion on average by 3.5 percentage points.
- Typical EU-15 frequent “sinners”: Greece, Ireland, Spain.
- Typical NMC frequent “sinners”: Estonia, Hungary, Latvia, Slovakia, Slovenia.
- “Saints” used to compute the reference inflation: often experienced substantial negative output gaps; low inflation among saints frequently coincided with GDP below potential.

### Price dispersion and policy implications
- The euro-area average inflation masks cross-country dispersion; eurozone policy (ECB) faces noise from divergent national inflation and cyclical conditions.
- The eurozone is not an optimal currency area; limited nonmonetary equilibrating mechanisms (capital and labor mobility) increase reliance on relative price and wage adjustments.
- Countries with persistently higher inflation risk long-term competitiveness losses unless offset by productivity growth.

### Disinflation strategies and trade-offs
- Two broad disinflation strategies:
  - Fiat disinflation (“low inflation now, reforms later”): uses short-term demand stabilization, administrative measures, changes in regulated prices, indirect tax changes, or temporary wage freezes.
    - Short-term: modest costs of disinflation, aided by “borrowed credibility” from the ECB.
    - Long-term: high costs due to structural rigidities and a flatter Phillips curve; future disinflations become more costly and monetary transmission weaker.
  - Reformist strategy: market-oriented structural reforms and credible monetary policy to permanently lower inflation via expectations and flexible markets.
    - Outcome: lower long-term disinflation costs due to more efficient monetary transmission and forward-looking agents.
- Incentives created by the criterion:
  - A tight one-year inflation criterion increases incentives for fiat measures to meet dates for euro entry.
  - A softer or cycle-adjusted criterion would reduce incentives for short-term administrative measures and favor reform.

### Modeling objectives and scope
- Two hypothetical questions addressed with a country-specific, calibrated model (Walsh (2003) framework):
  1. What output gap—resulting from a monetary policy action—would have been consistent with bringing inflation toward the Maastricht criterion?
  2. What is the magnitude of the sacrifice ratio for a uniform disinflation shock of 100 basis points?
- Caveats: simulations are hypothetical (some countries already in the eurozone, ECB responsibility for monetary policy, NMCs not necessarily seeking euro entry at the simulation date); results provide an upper-limit benchmark for plausible sacrifice ratios and enable cross-country comparisons of long-term disinflation costs.

*Source: IMF Working Paper chapter "EU Inflation Sinners" (excerpt).*

### Appendix II for further details).The aggregate spending relationship corresponds to the open

### References

### _wp06154 - References

### References (bibliography)
- Bibliographic list of works cited, including studies, working papers, journal articles, books, policy briefs, and institutional reports on topics such as:
  - euro adoption, exchange rate mechanisms, and EMU membership (e.g., Ahearne and Pisani-Ferry, 2006; Bini Smaghi, 1994; Giavazzi and Pagano, 1988).
  - inflation differentials, inflation persistence, and the Maastricht inflation criterion (e.g., Angeloni and Ehrmann, 2004; Hofmann and Remsperger, 2005; Honohan and Lane, 2003).
  - monetary policy transmission and structural/VAR model analyses for EU and accession countries (e.g., Arnoštová and Hurník, 2005; Ciccarelli and Rebucci, 2006; Mojon and Peersman, 2001).
  - sacrifice ratios, disinflation costs, and optimal monetary policy (e.g., Ball, 1994; Batini and Haldane, 1999; Cuñado and Pérez de Gracia, 2003).
  - country-specific analyses and central bank working papers for Czech Republic, Hungary, Poland, Slovakia, Slovenia, and others (e.g., Coats, Laxton, and Rose, 2003; Jakáb and Kovács, 2002; Kłos et al., 2005).
  - IMF and OECD reports and working papers addressing competitiveness, labor and product market reforms, and inflation-related policy issues (e.g., IMF Working Papers 06/81, 05/191; OECD Employment Outlook 2004).
- The references include explicit internet availability notes for many items (URLs provided in the source).

### Appendix I — THE MAASTRICHT INFLATION CRITERION: A SHORT HISTORY LESSON
- Purpose:
  - The Maastricht inflation criterion was designed as one of the instruments to stabilize the European currencies in preparation for the euro.
- Historical context and motivation:
  - Following the oil shock of 1973, Europe experienced great nominal divergence, which thwarted further progress toward economic and political integration.
  - When the nominal anchor of semi-fixed exchange rates failed, European authorities set simple and understandable targets to constrain fiscal and monetary policies in the EU.
- Institutional developments:
  - The European exchange rate mechanism (ERM) was introduced in March 1979 as part of the European Monetary System (EMS) to reduce exchange rate variability and achieve monetary stability in preparation for Economic and Monetary Union and the euro.
  - Despite institutional instruments to prevent exchange rate movements outside a specified level, macroeconomic conditions undermined the ERM: the dispersion of inflation rates increased steadily, peaking in the mid-1980s, and the differential between low-inflation and high-inflation countries remained in double digits until 1991.
  - The ERM eventually collapsed in the early 1990s owing to differing economic policies and conditions of its members.
- From ERM collapse to Maastricht Treaty:
  - The collapse of the ERM spurred further coordination among EU member countries, which surrendered some monetary independence.
  - The euro was established by provisions in the 1992 Maastricht Treaty: participation required meeting budget deficit, debt ratio, inflation, and interest rates criteria.
- Definition and interpretation of the inflation criterion:
  - The inflation criterion was defined as “an average rate of inflation, observed over a period of one year before the examination, that does not exceed by more than 1½ percentage points that of, at most, the three best performing Member States in terms of price stability” (European Central Bank, 2004).
  - The ECB interprets the Treaty provisions as follows:
    - The inflation rate is calculated using the increase in the 12-month average of the harmonized index of consumer prices (HICP) over the previous 12-month average.
    - The notion of “at most, the three best performing Member States in terms of price stability” is applied by taking the unweighted arithmetic average of the rate of inflation of the three EU countries with the lowest inflation and adding 1½ percentage points to that average.
    - Negative rates of inflation (e.g., Lithuania in 2004) were excluded from the average.
- Subsequent institutional changes:
  - In 1999, ERM2 replaced the original ERM, while the original Maastricht criteria were retained.
  - In May 2004, 10 new countries were admitted to the EU: the Czech Republic, Cyprus, Estonia, Hungary, Latvia, Lithuania, Malta, Poland, Slovakia, and Slovenia.
  - Seven of the NMCs—Cyprus, Estonia, Latvia, Lithuania, Malta, Slovakia, and Slovenia—entered ERM2 in 2004 and 2005; their inflation performance will be assessed accordingly.
- Footnotes and scope clarifications included in the appendix:
  - When referring to the European Union prior to 2004, the paper considers the EU-15 (Austria, Belgium, Denmark, Finland, France, Germany, Greece, Ireland, Italy, Luxembourg, The Netherlands, Portugal, Spain, Sweden, and the United Kingdom).
  - Article 109(j) of the Maastricht Treaty specified the macroeconomic conditions and framed the inflation criterion text quoted above.

### Appendix II — THE FACTORS OF INFLATION IN EU-15 COUNTRIES
- Objective:
  - Reviews several explanations for inflation differentials among EU-15 countries and indicates these explanations are subsequently reflected in the paper's simulations.
- Categories of explanations cited:
  - Price-level convergence.
  - Demand pressures.
  - “Structural” distortions.

*Source: _wp06154 - References (pdf content provided).*

### 1.  Inflation and the level of economic development

### 1.  Inflation and the level of economic development

### Heterogeneity of price levels and convergence-driven inflation
- Prices of nontradable goods and services tend to be substantially lower in countries with lower per capita GDP and vice versa.
- As poorer countries’ income converges toward richer countries, faster inflation in initially poorer countries can be expected to bring price levels in line.
- Historical relationship (Čihák and Holub, 2005): an increase in GDP per capita in purchasing power parity units relative to the EU average by 1 percent corresponds to an increase in the price level relative to the EU by 0.7-0.9 percent.
- Adjustment channels:
  - Higher domestic inflation with a stable currency vis-à-vis the euro.
  - Nominal appreciation of the domestic currency with a stable rate of inflation vis-à-vis the eurozone.
- Policy/institutional constraints:
  - Nominal appreciation channel partly closed for ERM2 countries and fully closed for eurozone countries (exchange rate fluctuations limited during ERM2; currency fixed thereafter).
- Expected duration of income-level differentials: on current trends, differentials are expected to close only in 10–25 years (Čihák and Holub, 2005).
- Maastricht criterion context:
  - The safety margin of the criterion—1½ percentage points above the rate of inflation in the three best-performing member states—should take care of most of this change in the price level.
  - Most recent studies estimating the Balassa-Samuelson effect did not find its impact above 1½ percentage points annually (see Mihaljek and Klau, 2006; review referenced).
  - Caveat: longer-term impact of large capital inflows in NMCs is difficult to estimate (Lipschitz, Lane, and Mourmouras, 2006).

### Inflation and aggregate demand
- Aggregate demand fluctuations explain a substantial part of the EU-15 inflation differential.
- Disinflations tend to be associated with output below potential via a short-run Phillips curve.
- Empirical association (2001–05): a cumulative output gap of more than 1 percent of GDP relative to the average was associated with inflation lower than the EU-15 average by 0.1 percent.
- In NMCs the gap–inflation nexus is less tight because:
  - Several NMCs underwent periods of massive disinflations requiring substantial demand contractions.
  - Measurement problems in national accounts in many NMCs.
- Capital inflows and exchange rate effects:
  - Capital inflows generate consumer booms and price pressures.
  - Exchange rate appreciation pushes inflation down through the import price channel.
  - In some countries (e.g., the Czech Republic or Poland) appreciation offset capital-inflow-driven price pressures.
- Maastricht criterion critique:
  - Member states’ cyclical stance is not taken into account in the Maastricht calculation, making the criterion at times unnecessarily tight (Buiter, 2004; Schadler and others, 2005).
  - Inflation in the three best-performing countries averaged about 1 percent during 1999–2005; early 2000s rate hovered below 0.5 percent and mid-2000s below 0.8 percent.
  - Fast-growing ERM2 countries would have to engineer relatively strong demand contractions to meet the Maastricht criterion during such low-inflation reference periods.
  - Example: Slovak National Bank (2005) inflation forecast for 2007–08 announced that “monetary conditions should, however, throughout the period remain moderately restrictive so as to avoid the complete closing of the output gap.”

### Inflation and market regulation
- Differences in product and labor market regulation affect both generation of cost pressures and transmission to consumer prices.
- Empirical pattern: countries with more protected product and labor markets have had higher average inflation rates than those with less protected markets.
- Product market effects:
  - Protected economies tend to have higher markups and slower pass-through of external price shocks to consumer price inflation.
  - Countries lagging in reform in 1998 (France, Greece, and Italy) still had not brought product market protection in 2003 to the median level (Conway, Janod, and Nicoletti, 2005).
- Labor market effects:
  - In protected economies trade unions have exerted strong wage pressures, manifested in fast growth in unit labor cost (example: Italy).
  - Progress toward less labor market protection was less pronounced; labor markets became less flexible in several EU-15 countries, offsetting EU policies of wage moderation (OECD, 2004; Estevão, 2005).
- Structural reform effects:
  - Reforms that increase competition in factor and product markets tend to result in lower long-term inflation.
  - Mechanisms:
    - Direct: smaller markups and more intensive price competition.
    - Indirect: more forward-looking expectations in flexible economies reduce the costliness of disinflation (Laxton and N'Diaye, 2002).

### Quantitative results (EU-15, 1996–2005)
- Empirical approach:
  - Panel regression (two-step generalized method of moments, GMM) of average inflation on relative PPP GDP per capita; GDP gap measure; and measures of structural reforms in product market, administrative, and labor market regulation.
  - To avoid simultaneity, the panel is estimated as a two-step GMM regression with appropriate instruments; one lag for instruments; other instruments include trend-based output gap and U.S. dollar GDP per capita relative to Denmark.
- Main findings:
  - EU-15 inflation during 1996–2005 associated mostly with variability of the output gap and structural reform variables.
  - GDP per capita was not statistically significant in the regression but omitting it can generate omitted-variable bias; coefficients comparable with Čihák and Holub (2005).
- Quantitative magnitudes:
  - An output gap of 1 percent associated with a reduction in annual inflation of about 0.3–0.4 percent.
  - More regulation in product or labor markets by one sample standard deviation associated with a rise in inflation by 0.3–1.0 percent.
- Interpretation for EU-15:
  - Apart from relatively high sacrifice ratios, impact of past reforms (or lack thereof) drives inflation.
  - Lack of structural reforms may push inflation up via:
    - Cost-push channels (markup or wage-cost pressures).
    - Greater persistence of inflation through its effect on the monetary transmission mechanism.

### Empirical table highlights (Table A2.1 — determinants of European inflation, 1996–2005)
- Dependent variable: annual rate of inflation; panel for EU-15 excluding Luxembourg; observations: 140.
- Selected coefficient estimates and statistics (preserved exactly as reported):
  - GDP per capita coefficients: -1.835 (1.22), -1.121 (0.91), -1.126 (0.77), -1.498 (0.92) across specifications A–D.
  - Output gap coefficients: 0.429** (5.53), 0.409** (5.44), 0.337** (4.49), 0.374** (4.80) across A–D.
  - Product market regulation (specification A): 1.91** (3.81).
  - Administrative regulation (specification B): 0.237 (1.57).
  - Labor market regulation (specification C): 0.671* (2.09).
  - Index of regulation (specification D): 0.980* (2.41).
  - R-squared values: 0.70, 0.66, 0.68, 0.68 for specifications A–D respectively.
- Note on significance: * significant at 5 percent; ** significant at 1 percent.
- Note on measurement: GDP per capita measured in PPP terms and expressed as a ratio to Denmark’s GDP; output gap measured in percent of potential output (production-function-based estimate in AMECO); regulation indices based on Conway, Janod, and Nicoletti (2005) and OECD (2004); observations linearly interpolated.

### Model structure and calibrations (appendix summary)
- Model equations (1)–(9) represent:
  1. Aggregate demand
  2. Aggregate supply
  3. Import price formation
  4. Inflation expectations formation
  5. Uncovered interest rate parity
  6. Policy reaction function
  7. Interest rate term structure
  8. Fisher equation
  9. Real exchange rate formation
- Steady-state normalization:
  - Steady-state values of steady-state variables normalized to zero.
  - Foreign inflation and interest rates normalized to zero.
  - Steady-state domestic nominal interest rate equals inflation; steady-state real interest rate equals zero.
  - Steady-state nominal exchange rate change equals difference between domestic and foreign inflation.
- Calibration methodology: parameters calibrated following Coats, Laxton, and Rose (2003) and Berg, Karam, and Laxton (2006); replicate Phillips curve estimates summarized in Rumler (2005); remaining parameters set to mimic known features of individual economies.
- Key cross-country calibration features:
  - Old member states: variation in persistence and expectations formation.
    - Greece: low persistence in IS and Phillips curves; financial markets mostly backward-looking; persistent exchange rates.
    - Ireland: monetary policy reacts quickly and forcefully through exchange rate channel; strong gap–inflation nexus.
    - Italy: highly persistent economy; flat Phillips curve; compensated by reactive monetary policy (low persistence in policy rates).
    - Spain: highly persistent with a Phillips curve somewhat steeper than Italy.
  - NMCs: comparable persistence across real economies and inflation, differing in Phillips curve slopes and forward-looking financial markets.
    - Czech Republic: not particularly flexible; steep Phillips curve; largely forward-looking financial markets.
    - Hungary: least favorable monetary policy environment; flat Phillips curve; mostly backward-looking exchange rate behavior; sluggish monetary policy reactions.
    - Poland: quick direct exchange rate channel supplemented with lagged output gap channel producing a “two-peak” inflation response to monetary shocks.
    - Slovakia: mostly backward-looking financial markets; sluggish monetary policy reactions; Phillips curve steepness below sample average.
    - Slovenia: backward-looking financial markets; sluggish monetary policy reactions; steep Phillips curve reducing cost of disinflation.
- Parameter tables (Table A3.2) provide country-specific parameter values (examples preserved exactly in the source; see table for full calibration).

### Empirical and simulation evidence on sacrifice ratios and disinflation
- Sacrifice ratio definition: cumulative GDP loss associated with 100 basis point disinflation.
- Table A3.3 selected estimates (preserved exactly as reported):
  - Ball (1994) — Ireland (1960-91): 2.9; Italy: 5.9; Spain: 3.6.
  - Cecchetti and Ehrmann (1999) — Ireland, Italy, Spain (1984-97): 4.6, 9.3, 3.3.
  - Stasavage (2003) — Italy, Spain, The Czech Republic, Slovakia (1990-99): 1.7, 1.8, 1.8, -1.9.
  - Cuñado and de Gracia (2003) — Ireland, Spain (1960–2001): 0.9, 1.7.
  - Diana and Sidiropoulos (2004) — Ireland (1960-90): Between 0.4 and 0.9.
  - Bayoumi, Laxton, and Pesenti (2004) — The eurozone (Simulation): Between 1.4 and 2.0.
  - Bárta (2006) — The Czech Republic (Simulation): 1.0.
  - International Monetary Fund (2006) — The eurozone: 2.1; EU-15: 1.4; NMCs: 1.6 (Simulations in the Global economy model (GEM)).
- Simulated disinflation trajectories (Figure A3.1) illustrate country-specific paths (interest rates, inflation, exchange rate changes, real interest rate gap, output gap, cumulative output gap) with specified start and end inflation points preserved exactly:
  - Greece: Disinflation from 3.2 percent to 2.6 percent.
  - Ireland: Disinflation from 4.6 percent to 2.9 percent.
  - Spain: Disinflation from 3.0 percent to 2.6 percent.
  - The Czech Republic: Disinflation from 3.9 percent to 2.7 percent.
  - Hungary: Disinflation from 5.5 percent to 2.6 percent.
  - Poland: Disinflation from 3.1 percent to 2.0 percent.
  - Slovakia: Disinflation from 8.6 percent to 2.7 percent.
  - Slovenia: Disinflation from 5.2 percent to 2.7 percent.

*Source: _wp06154 - 1.  Inflation and the level of economic development (IMF PDF chapter).*

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_Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/wp/2006/_wp06154.pdf_