## 1. Defining Country-Specific Inflation

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---

### Introduction and research questions
- Primary questions: Does globalization reduce the level of inflation? Does it change inflation dynamics?
- Study focus: a relatively homogenous region (the European Union) over a recent, relatively short period, 2002 and 2005, with empirical analysis using Eurostat’s monthly Harmonized Index of Consumer Prices (HICP) from January 2001 to December 2005.
- Literature summarized (preserve cited years and authors exactly): Rogoff (2004, 2006); Ball (2006); IMF (2006); Woodford (2007); Razin and Binyamini (2007); Borio and Filardo (2007); Ihrig et al. (2007); Mishkin (2007); Daniels and VanHoose (2006); Marimon and Zilibotti (1998); Stockman (1988); Froot and Rogoff (1991); Goldberg and Verboven (2001, 2005); Rogers (2002 and forthcoming); Honohan and Lane (2003); Angeloni and Ehrmann (2004); Fuhrer (2005); Lumsdaine and Prasad (2003); Gutierrez (2003); Hanousek and Filer (2004); Hoffmann (1998); Ball (1994); Romer (1993).

### Key conceptual insights and observed patterns
- Market integration manifests as price equalization across nations; where price convergence has been achieved, prices tend to move together.
- The common component of consumer price inflation is defined as due to either common sectoral or time-varying inflation rates (per Marimon and Zilibotti (1998)).
- Comovement of prices is stronger within the eurozone than outside it.
- Country-specific inflation is defined as the difference between overall inflation and the common (external) inflation.
- Eurozone vs non-eurozone differences:
  - Eurozone countries appear tightly integrated and small deviations in prices are quickly arbitraged away.
  - Non-eurozone countries exhibit a longer-term catch-up process; recently the catch-up has accelerated, especially outside the eurozone due to integration of new member states.
- Tradable vs non-tradable goods:
  - Catch-up speed for tradables is broadly similar throughout Europe.
  - Catch-up for non-tradables is significantly slower in non-eurozone countries.

### Decomposition methodology (exact equations and identification)
- Decomposition approach follows Marimon and Zilibotti (1998) and Stockman (1988); contrasts with generalized dynamic factors model (GDFM).
- Exact decomposition equation as presented in the source:
  ()()()()
  ()()( )
  t,n,is,mtime_cym,jcy_prod
  s,jtime_prodstimejprodt,n,i
  NT
  time_cy
  s,m
  IN
  cy_prod
  m,j
  IT
  time_prod
  s,j
  T
  time
  s
  I
  prod
  j
  εββ
  βββπ
  +++
  ++=
  ∑∑∑∑
  ∑∑∑∑
  1111
  1111
     (1) 
  i, j = 1,...I,  n, m = 1,...N,   t, s = 1,...T, 
- Definitions from the source:
  - π(i,n,t) is the overall inflation rate for product “i” in country “n” at time “t,” measured as the difference between the log of the price index in a particular month relative to the same month in the previous year.
  - Time dummies time(s) proxy the inflation component common across all countries and product groups (EU-wide inflation).
  - prod(j) is the average inflation rate for product j.
  - prod_time(j,s) captures product-specific time-varying dynamics.
  - Country-specific effects are prod_cy(j,m), cy_time(m,s), and ε(i,n,t).
  - Identification: product dummy prod(j) is left unrestricted and all groups of dummies are restricted to add up to zero so they are interpreted as deviations from product inflation trends.
- Exact identification restrictions as presented in the source:
  ∑
  ∑
  ∑
  ∑
  ∑
  ∑
  =
  =∀=
  =∀=
  =∀=
  =∀=
  =∀=
  T
  time
  s
  N
  time_cy
  s,m
  T
  time_cy
  s,m
  I
  time_prod
  s,j
  T
  time_prod
  s,j
  N
  cy_prod
  m,j
  .
  ;T,...,s
  ;N,...m
  ;T,...s
  ;I,...j
  ;I,...,j
  1
  1
  1
  1
  1
  1
  0
  10
  10
  10
  10
  10
  β
  β
  β
  β
  β
  β
        (2) 
- Data scope explicitly preserved:
  - 25 member countries of the European Union
  - Eurostat monthly HICP
  - January 2001 to December 2005
  - 51 three-digit product groups

### Common (EU-wide) component and its drivers (exact reported empirical relation)
- Figure 2 in the source reports the EU-wide time-varying common component; this common inflation is related to changes in oil prices (especially until early 2005) and interacts with industrial production growth.
- Exact empirical relation as presented in the source (preserve original formatting and numbers):
  72.0
  )37.6(
  *51.12
  )86.1()12.0()08.0()03.0(
  0.228.074.009.0
  2
  1
  =
  +
  −++−=
  −
  R
  growthproductionindustrialpriceoil
  growthproductionindustrialpriceoil
  tt
  ππ

### Virtual inflation and country-specific inflation (definitions)
- Virtual inflation (per Marimon and Zilibotti (1998)):
  - For product i at time t: VIRT t,i = prod(i) + time_prod(i,t) + time(t)βββπ++= (presented in source as)
  ()
  time_prod
  t,i
  time
  t
  prod
  i
  VIRT
  t,iβββπ++=
- Virtual inflation for a country is the weighted average of product-level virtual inflations, with weights given by the share of consumption of each product in that country.
- Country-specific inflation = actual inflation − virtual inflation.
  - Important implication: country-specific inflation does not include “excess” inflation due to the structure of the country’s consumption basket.

### Determinants and policy-relevant findings (preserved conclusions)
- Domestic conditions matter in driving the country-specific component of inflation.
- The output gap plays a role mainly in the eurozone.
- Effects of the output gap and of wage pressures on inflation are weakened by trade openness in the eurozone.
- External conditions have been more important outside the eurozone; depreciation of the nominal exchange rate has a more pronounced effect in raising domestic prices outside the eurozone.
- Implications for policy:
  - Globalization reduces the quantitative importance of country-specific inflation, limiting scope for purely domestic policy to modulate inflation.
  - Greater trade openness weakens the link between domestic demand and country-specific price setting.
  - A significant portion of country-specific inflation reflects the equalization, over time, in price levels (Balassa-Samuelson effect and quality convergence), which can be quantitatively large for poorer European countries.

### Box 1: Defining Country-Specific Inflation — Definition and calculation
- Country-specific inflation is calculated as headline inflation less overall virtual inflation for each country.
- Construction steps:
  - The virtual inflation rate for each product in each country is first converted into a virtual price index based on 2001 actual product price indices in each country P_VIRT(n,i,t).
  - The indices are chainlinked using the country-specific HICP product weights into an aggregate virtual price index P_VIRT(n,m,t) in country n in month m of year t that takes into account the country-specific consumption structure:
    - (Equation text as presented in source)
      () () () () t,n,i w t,Dec,n,iP t,m,n,iP Pt,m,nP m VIRT VIRT VIRT t,Dec,n VIRT ∑ = − − = 12 1 1 1  .
  - Virtual and country-specific inflation rates in country n in month m of year t are defined as:
    - () () () () ()() () ,, ln,,ln,, 1 VIRTVIRTVIRT CYSPECHEADLINEVIRT nmtPnmtPnmt nmtnmtnmt π ππ π =−− =−
- Practical implication: country-specific inflation isolates the component of inflation that is not explained by the constructed common (virtual) inflation component.

### Box 1: Empirical patterns and descriptive findings (exact figures)
- Average country-specific inflation (top panel of Figure 3) and shares (bottom panel of Figure 3):
  - “Northern” eurozone countries: average country-specific inflation of -0.5 percent a year over the sample period.
  - “Southern” eurozone countries (Spain, Greece, and Portugal): country-specific inflation of 0.7 percent a year.
  - Outside the eurozone, northern (more advanced) countries (the UK, Sweden, and Denmark): country-specific inflation was -1.0 percent a year.
  - New members of the European Union from Central and Eastern Europe: country-specific inflation of 0.8 percent.
  - In the eurozone nations, the share of country-specific inflation is between a quarter and one-third of actual inflation.
  - Outside the eurozone, country-specific inflation is about two-thirds of actual inflation.
  - Cyprus and Malta: virtually no country-specific inflation (noted as standing out with low country-share of inflation).
- Variance decomposition (Figure 4): the variance explained by country-specific inflation is relatively low inside the eurozone.
- Price convergence (Figure 5): richer countries (inside and outside the eurozone) with higher price levels have had, on average, negative country-specific inflation; poorer countries with lower price levels have had positive country-specific inflation.

### Empirical specification and estimation (Box 1)
- Dependent variable: year-on-year country-specific inflation.
- Data: four years or 16 quarters, from 2002: I to 2005: IV; panel dimension; random-effects model used to exploit cross-sectional variation.
- Baseline regression (symbolic form preserved as presented in source):
  - t,it ,s tsts, ,s * st,ist,is, ,s sts, ,s sts,t,it,i PRelVATTRADETRADE*ULC% yyULC%NEER% εββββ βββπββπ ++Δ++Δ+ −+Δ+Δ++= − = −− = −− = − = −− = 20018746 40 45 40 4 40 3 40 2110
- Key explanatory variables included:
  - Lagged inflation term (captures persistence).
  - Output gap: () * , , t i t i yy − , in percent of potential GDP based on potential output derived from an HP filter applied to the maximum available length of the time series for each country.
  - Year-on-year growth rate of unit labor costs in the manufacturing sector: st ULC% − Δ.
  - Interactions of output gap and unit labor costs with trade openness ((exports plus imports)/GDP).
  - Year-on-year percent change in the trade-weighted nominal effective exchange rate against 41 partner countries: st NEER% − Δ.
  - Year-on-year VAT rate changes.
  - Initial (2001) price level relative to the EU-25 to capture catch-up effects.
- Lags: contemporaneous value and a one-year lag included for output gap, unit labor cost growth, and nominal effective exchange rate appreciation.

### Baseline regression: main findings for the eurozone (Table 1)
- Persistence:
  - Estimate of inflation persistence for the eurozone at about 80 percent.
  - Comparable estimates: Borio and Filardo (2007) 90 percent; Batini (2002) 70 percent; Rogers (forthcoming) just below 80 percent.
- Output gap and unit labor cost:
  - When the lagged inflation term is included, output gap and unit labor cost growth have expected positive signs but neither is significant at the conventional 5 percent level (column 1).
  - Interaction with trade openness: transmission from output gap and unit labor cost to domestic inflation is dampened by the degree of trade openness (columns 2 and 3).
  - Dampening influence is statistically more important for unit labor cost growth; at the mean value of trade openness, labor cost growth has a positive and significant relationship with domestic inflation.
- Role of lagged inflation term:
  - Removing the lagged term increases partial correlations between especially the output gap, but also unit labor cost and domestic inflation—suggesting persistence partly reflects transmission lags from output gap and unit labor cost (“inherited” inflation).
- Price-level catch-up:
  - Lower initial price level → higher subsequent inflation.
  - With lagged term removed, a country with a price level one-third below the EU average will experience an additional one percent a year in price inflation compared to the EU average.
  - Column 4 produces an estimate very close to Honohan and Lane (2003); Rogers (2002) also obtains a very similar estimate.
- Nominal effective exchange rate:
  - Expected negative sign; depreciation raises the inflation rate and is significant in specifications that include the lagged inflation term.
- Overall inflation regressions:
  - Findings for overall inflation are less informative; country-specific right-hand side variables are poorly correlated with overall inflation, since overall inflation is largely driven by common international sectoral and time trends.
- Selected numeric regression highlights (Table 1):
  - Lagged dependent variable (reported values): 0.80, 0.80, 0.79, ... 0.74. Robust P-values: [0.00]***, [0.00]***, [0.00]***, ... [0.00]***.
  - Cumulative coefficients (contemporaneous + 1-year lag) examples:
    - Output gap: 0.09, 0.24, 0.09, 0.39, 0.04. F-test (Prob>F): [0.11], [0.04]**, [0.13], [0.00]***, [0.65].
    - NEER: -0.04, -0.04, -0.04, 0.00, -0.01. F-test (Prob>F): [0.03]**, [0.02]**, [0.02]**, [0.97], [0.64].
    - ULC: 0.02, 0.06, 0.06, 0.13, 0.04. F-test (Prob>F): [0.11], [0.00]***, [0.00]***, [0.00]***, [0.12].
  - Observations: 179, 179, 179, 191, 179.
  - Number of countries: 12, 12, 12, 12, 12.
  - R-squared (within): 0.67, 0.68, 0.68, 0.25, 0.46.

### Non-eurozone comparisons and distinctions (Table 2)
- General: inflation in non-eurozone countries is driven by broadly similar features; the same model provides a good description of the inflationary process.
- Persistence: persistence coefficient about 80 percent, similar to the eurozone.
- Output gap:
  - For the noneurozone, the output gap is never statistically significant.
  - Possible reasons: these relatively open economies (ratio of trade to GDP is 0.87 outside the eurozone, relative to 0.74 inside) may transmit cyclical demand conditions less into domestic price movements; or output gap may be mismeasured in some new member states.
- Unit labor costs:
  - When lagged price level is included, interaction of unit labor cost growth with trade is negative and mildly significant; overall effect of rising wages at the mean level of trade openness is insignificant (unlike the eurozone, where it is positive and significant).
  - Removing the lagged term makes real wage growth more potent—suggesting structural factors and longer transmission lags in noneurozone countries.
- Nominal effective exchange rate:
  - Has a much greater quantitative influence in the noneurozone than in the eurozone.
- Initial price level coefficient:
  - In noneurozone, the coefficient on initial price level is smaller in magnitude than in the eurozone.
  - Catch-up speeds are similar for tradable goods in eurozone and noneurozone, but lower for non-tradable goods outside the eurozone.
- Selected numeric regression highlights (Table 2):
  - Lagged dependent variable (reported values): 0.78, 0.78, 0.78, 0.78, ... 0.72. Robust P-values: [0.00]***.
  - Cumulative coefficients (contemporaneous + 1-year lag) examples:
    - NEER: -0.10, -0.11, -0.11, -0.14, -0.26, -0.12. F-test (Prob>F): [0.00]*** across reported columns.
    - ULC: 0.02, 0.11, 0.12, 0.16, 0.29, 0.12. F-test (Prob>F): [0.3], [0.11], [0.05]*, [0.04]**, [0.00]***, [0.09]*.
  - Observations: 165, 165, 165, 120, 176, 165.
  - Number of countries: 11, 11, 11, 8, 11, 11.

### Traded vs Non-Traded goods (Table 3 and discussion)
- Eurozone:
  - The output gap has some cyclical (or contemporary) influence on inflation of traded-goods prices.
  - For both traded and non-traded goods, significant transmission lags are absorbed in the lagged inflation term.
  - Price catch-up process has worked faster inside the eurozone than outside it for both traded and non-traded goods.
  - Catch-up is weaker in the non-traded goods sectors.
- Outside the eurozone:
  - The output gap does not appear to matter for traded or non-traded goods (in line with aggregate results).
  - Growth in unit labor cost is more of a factor outside the eurozone, with slow transmission lags that are part of inflation persistence.
  - Unit labor costs play more of a role in non-traded goods where competition forces are weaker; effect is somewhat greater outside the eurozone (consistent with Balassa-Samuelson effect), but the size of the effect is small.
  - The nominal effective exchange rate plays a much more important role outside the eurozone and does so through traded rather than non-traded goods.
  - The effect of VAT rate increases is stronger on non-traded goods.
- Selected numeric examples (Table 3):
  - NEER:
    - Eurozone Nontradables: -0.02 (F-test [0.27]).
    - Eurozone Tradables: 0.03 (F-test [0.49]).
    - Non-Eurozone Nontradables: -0.11 (F-test [0.00]***).
    - Non-Eurozone Tradables: -0.19 (F-test [0.00]***).
  - ULC:
    - Eurozone Nontradables: 0.05 (F-test [0.15]).
    - Eurozone Tradables: 0.09 (F-test [0.11]).
    - Non-Eurozone Nontradables: 0.14 (F-test [0.01]**).
    - Non-Eurozone Tradables: 0.17 (F-test [0.03]**).

### Time splits and shifts over the sample (Table 4 and narrative)
- Shifts over time:
  - Influence of domestic output gap remained salient in the eurozone and may have increased in 2004/2005 relative to 2002/2003.
  - Effect of the nominal effective exchange rate decreased in importance inside the eurozone but increased outside, making differences starker.
  - Importance of unit labor costs modestly increased in the eurozone (mainly for non-traded goods) and declined outside, narrowing coefficient differences.
  - Price convergence effects increased in both eurozone and non-eurozone countries (for both traded and non-traded goods); the price convergence effect rose from negligible in the first half of the sample to a more sizeable and statistically significant effect in the last two years of the sample (still smaller outside the eurozone than inside).
  - Effect of VAT rate changes declined over time both inside and outside the eurozone, for both traded and non-traded goods.
- Supporting numeric and contextual points:
  - The standard deviation of nominal effective appreciation across eurozone countries declined, on average, from 0.9 in the first half to 0.4 percent in the second half.
- Time-split numeric highlights (Table 4 examples):
  - Relative price level in 2001 (EU25=1): large negative coefficients in several 2004/2005 columns (e.g., -2.89, -4.00) with p-values [0.00]***.
  - Maximum change in VAT rate over past year: positive and often significant coefficients (examples 0.47 [0.00]***; 1.07 [0.06]*; 0.39 [0.00]***).

### Role of administrative/tax decisions (VAT)
- VAT rate changes raised inflation in both the eurozone and outside it.
- Quantitative details:
  - On average over the sample period, VAT rates changed by 0.32 percentage points outside the eurozone compared to 0.06 percentage points inside it.
  - Applying the two regression coefficients implies that, on average, VAT rate changes contributed 0.09 percentage points to inflation outside the eurozone compared to 0.03 percentage points inside it.

### Disinflation episodes in Europe — Key findings and examples
- General observation:
  - Globalization reduces the country-specific component of inflation and dampens transmission of domestic demand to country-specific inflationary pressure.
  - Outside the eurozone, domestic demand (output gap or wage growth) has had limited influence on domestic inflation, reducing policymakers’ degrees of freedom to reduce inflation.
- Country cases summarized in source:
  - Lithuania: low inflation in 2002 and 2003 partly due to wage restraint and largely due to an appreciation of its nominal effective exchange rate; price catch-up pressure expected to make a significant contribution going forward.
  - Portugal: 1995 stabilization and EMU accession dynamics led to inflation rising above the Maastricht reference value by end-1998 and remaining above it almost continuously until mid-2005; trade accounted for 57 percent of GDP in 1994 compared to average 87 percent in non-eurozone sample.
  - Spain: labor market reforms and fiscal consolidation helped meet Maastricht criterion by January 1998 but inflation rose again and stayed above since mid-1999.
  - Greece: fiscal consolidation and high policy effort reduced inflation from 9 percent in 1995 to 2¼ percent in 1999; loosened policies after EMU accession raised inflation above Maastricht reference within half a year.
  - Ireland: fiscal consolidation and high real interest rates earlier kept inflation moderate; ECB policy loosening at EMU accession contributed to inflation rising above the Maastricht reference by January 1999 and remaining above until mid-2005.
- Common pattern:
  - Rapid disinflation episodes in the EU have been associated with large fiscal adjustments, supported by monetary and structural policies.
  - For new member states relinquishing monetary policy, the burden on fiscal policy to achieve disinflation could be huge.
  - Structural reforms and continued increase in economic flexibility are necessary; no single structural measure is likely to be sufficient.

### Conclusions and policy implications
- Mechanisms linking globalization and inflation:
  - Globalization reduces scope for domestically-generated inflation via integrated product markets.
  - Globalization may break the link between domestic demand conditions and price setting as trading possibilities limit market power.
  - Country-specific inflation can be driven by price catch-up, a process largely outside policymakers’ control.
- Balassa-Samuelson and unit labor costs:
  - Unit labor cost growth is more potent in raising prices of non-traded goods than of traded goods.
  - This force is somewhat more prominent outside the eurozone.
- Price catch-up:
  - Catch-up has worked more slowly in non-traded sectors but has accelerated, including in non-traded goods, even in the short period covered by the study.
  - If price catch-up accelerates, policymakers will have limited leverage and may have little reason to oppose it; catch-up does not constitute the same kind of “inefficient” inflation as lack of policy credibility.
- Fiscal policy and disinflation:
  - Substantial fiscal consolidations may be needed to reduce inflation by significant margins.
  - Such consolidations may be difficult to sustain and therefore may only achieve temporary reductions in inflation.
- Overall implication:
  - Because of internationalization forces, domestic policies will have increasingly smaller scope in curbing inflation; the pace of structural change and continued integration will shape future inflation dynamics.

### Appendix: Data, sources, and selected regression tables (high-level)
- Dependent variable and sample:
  - Monthly HICP index for January 2001−December 2005 (2005=100).
  - Panel regression dependent variable: Year-on-year log difference in the actual HICP minus year-on-year log difference in the virtual HICP.
  - Source: Eurostat.
- Key independent variables and sources include Eurostat, Haver Analytics, European Commission.
- Missing-data detail: country-by-commodity missing series listed in source (specific items and countries preserved there).
- Selected regression table statistics and figure captions are reported in the source (Tables 1–4, Figures 1–7; Appendix Tables 6–7) with exact numeric entries and significance indicators preserved in the source text.

*Source: IMF staff paper section titled "1. Defining Country-Specific Inflation" (content unit from the provided PDF). *

### 1. Defining Country-Specific Inflation ...........................................................................9

### 1. Defining Country-Specific Inflation

### Introduction and research questions
- Primary questions: Does globalization reduce the level of inflation? Does it change inflation dynamics?
- Literature summarized (preserve cited years and authors exactly): Rogoff (2004, 2006); Ball (2006); IMF (2006); Woodford (2007); Razin and Binyamini (2007); Borio and Filardo (2007); Ihrig et al. (2007); Mishkin (2007); Daniels and VanHoose (2006); Marimon and Zilibotti (1998); Stockman (1988); Froot and Rogoff (1991); Goldberg and Verboven (2001, 2005); Rogers (2002 and forthcoming); Honohan and Lane (2003); Angeloni and Ehrmann (2004); Fuhrer (2005); Lumsdaine and Prasad (2003); Gutierrez (2003); Hanousek and Filer (2004); Hoffmann (1998); Ball (1994); Romer (1993).

- Study focus: a relatively homogenous region (the European Union) over a recent, relatively short period, 2002 and 2005, with empirical analysis using Eurostat’s monthly Harmonized Index of Consumer Prices (HICP) from January 2001 to December 2005.

### Key conceptual insights and observed patterns
- Market integration manifests as price equalization across nations; where price convergence has been achieved, prices tend to move together.
- The common component of consumer price inflation is defined as due to either common sectoral or time-varying inflation rates (per Marimon and Zilibotti (1998)).
- Comovement of prices is stronger within the eurozone than outside it.
- Country-specific inflation is defined as the difference between overall inflation and the common (external) inflation.
- Eurozone vs non-eurozone differences:
  - Eurozone countries appear tightly integrated and small deviations in prices are quickly arbitraged away.
  - Non-eurozone countries exhibit a longer-term catch-up process; recently the catch-up has accelerated, especially outside the eurozone due to integration of new member states.
- Tradable vs non-tradable goods:
  - Catch-up speed for tradables is broadly similar throughout Europe.
  - Catch-up for non-tradables is significantly slower in non-eurozone countries.

### Decomposition methodology (exact equations and identification)
- Decomposition approach follows Marimon and Zilibotti (1998) and Stockman (1988); contrasts with generalized dynamic factors model (GDFM).
- Exact decomposition equation as presented in the source:
  ()()()()
  ()()( )
  t,n,is,mtime_cym,jcy_prod
  s,jtime_prodstimejprodt,n,i
  NT
  time_cy
  s,m
  IN
  cy_prod
  m,j
  IT
  time_prod
  s,j
  T
  time
  s
  I
  prod
  j
  εββ
  βββπ
  +++
  ++=
  ∑∑∑∑
  ∑∑∑∑
  1111
  1111
     (1) 
  i, j = 1,...I,  n, m = 1,...N,   t, s = 1,...T, 

- Definitions from the source:
  - π(i,n,t) is the overall inflation rate for product “i” in country “n” at time “t,” measured as the difference between the log of the price index in a particular month relative to the same month in the previous year.
  - Time dummies time(s) proxy the inflation component common across all countries and product groups (EU-wide inflation).
  - prod(j) is the average inflation rate for product j.
  - prod_time(j,s) captures product-specific time-varying dynamics.
  - Country-specific effects are prod_cy(j,m), cy_time(m,s), and ε(i,n,t).
  - Identification: product dummy prod(j) is left unrestricted and all groups of dummies are restricted to add up to zero so they are interpreted as deviations from product inflation trends.

- Exact identification restrictions as presented in the source:
  ∑
  ∑
  ∑
  ∑
  ∑
  ∑
  =
  =∀=
  =∀=
  =∀=
  =∀=
  =∀=
  T
  time
  s
  N
  time_cy
  s,m
  T
  time_cy
  s,m
  I
  time_prod
  s,j
  T
  time_prod
  s,j
  N
  cy_prod
  m,j
  .
  ;T,...,s
  ;N,...m
  ;T,...s
  ;I,...j
  ;I,...,j
  1
  1
  1
  1
  1
  1
  0
  10
  10
  10
  10
  10
  β
  β
  β
  β
  β
  β
        (2) 

- Data scope explicitly preserved:
  - 25 member countries of the European Union
  - Eurostat monthly HICP
  - January 2001 to December 2005
  - 51 three-digit product groups

### Common (EU-wide) component and its drivers (exact reported empirical relation)
- Figure 2 in the source reports the EU-wide time-varying common component; this common inflation is related to changes in oil prices (especially until early 2005) and interacts with industrial production growth.
- Exact empirical relation as presented in the source (preserve original formatting and numbers):
  72.0
  )37.6(
  *51.12
  )86.1()12.0()08.0()03.0(
  0.228.074.009.0
  2
  1
  =
  +
  −++−=
  −
  R
  growthproductionindustrialpriceoil
  growthproductionindustrialpriceoil
  tt
  ππ

### Virtual inflation and country-specific inflation (definitions)
- Virtual inflation (per Marimon and Zilibotti (1998)):
  - For product i at time t: VIRT t,i = prod(i) + time_prod(i,t) + time(t)βββπ++= (presented in source as)
  ()
  time_prod
  t,i
  time
  t
  prod
  i
  VIRT
  t,iβββπ++=
- Virtual inflation for a country is the weighted average of product-level virtual inflations, with weights given by the share of consumption of each product in that country.
- Country-specific inflation = actual inflation − virtual inflation.
  - Important implication: country-specific inflation does not include “excess” inflation due to the structure of the country’s consumption basket.

### Determinants and policy-relevant findings (preserved conclusions)
- Domestic conditions matter in driving the country-specific component of inflation.
- The output gap plays a role mainly in the eurozone.
- Effects of the output gap and of wage pressures on inflation are weakened by trade openness in the eurozone.
- External conditions have been more important outside the eurozone; depreciation of the nominal exchange rate has a more pronounced effect in raising domestic prices outside the eurozone.
- Implications for policy:
  - Globalization reduces the quantitative importance of country-specific inflation, limiting scope for purely domestic policy to modulate inflation.
  - Greater trade openness weakens the link between domestic demand and country-specific price setting.
  - A significant portion of country-specific inflation reflects the equalization, over time, in price levels (Balassa-Samuelson effect and quality convergence), which can be quantitatively large for poorer European countries.

*Source: IMF staff paper section titled "1. Defining Country-Specific Inflation" (content unit from the provided PDF).*

### Box 1: Defining Country-Specific Inflation

### Box 1: Defining Country-Specific Inflation

### Definition and calculation
- Country-specific inflation is calculated as headline inflation less overall virtual inflation for each country.
- Construction steps:
  - The virtual inflation rate for each product in each country is first converted into a virtual price index based on 2001 actual product price indices in each country P_VIRT(n,i,t).
  - The indices are chainlinked using the country-specific HICP product weights into an aggregate virtual price index P_VIRT(n,m,t) in country n in month m of year t that takes into account the country-specific consumption structure:
    - (Equation text as presented in source)
      () () () () t,n,i w t,Dec,n,iP t,m,n,iP Pt,m,nP m VIRT VIRT VIRT t,Dec,n VIRT ∑ = − − = 12 1 1 1  .
  - Virtual and country-specific inflation rates in country n in month m of year t are defined as:
    - () () () () ()() () ,, ln,,ln,, 1 VIRTVIRTVIRT CYSPECHEADLINEVIRT nmtPnmtPnmt nmtnmtnmt π ππ π =−− =−
- Practical implication: country-specific inflation isolates the component of inflation that is not explained by the constructed common (virtual) inflation component.

### Empirical patterns and descriptive findings
- Average country-specific inflation (top panel of Figure 3) and shares (bottom panel of Figure 3):
  - “Northern” eurozone countries: average country-specific inflation of -0.5 percent a year over the sample period.
  - “Southern” eurozone countries (Spain, Greece, and Portugal): country-specific inflation of 0.7 percent a year.
  - Outside the eurozone, northern (more advanced) countries (the UK, Sweden, and Denmark): country-specific inflation was -1.0 percent a year.
  - New members of the European Union from Central and Eastern Europe: country-specific inflation of 0.8 percent.
  - In the eurozone nations, the share of country-specific inflation is between a quarter and one-third of actual inflation.
  - Outside the eurozone, country-specific inflation is about two-thirds of actual inflation.
  - Cyprus and Malta: virtually no country-specific inflation (noted as standing out with low country-share of inflation).
- Variance decomposition (Figure 4): the variance explained by country-specific inflation is relatively low inside the eurozone.
- Price convergence (Figure 5): richer countries (inside and outside the eurozone) with higher price levels have had, on average, negative country-specific inflation; poorer countries with lower price levels have had positive country-specific inflation.

### Determinants and empirical specification
- Dependent variable: year-on-year country-specific inflation.
- Data: four years or 16 quarters, from 2002: I to 2005: IV; panel dimension; random-effects model used to exploit cross-sectional variation.
- Baseline regression (specification presented in source; symbolic form preserved):
  - t,it ,s tsts, ,s * st,ist,is, ,s sts, ,s sts,t,it,i PRelVATTRADETRADE*ULC% yyULC%NEER% εββββ βββπββπ ++Δ++Δ+ −+Δ+Δ++= − = −− = −− = − = −− = 20018746 40 45 40 4 40 3 40 2110
- Key explanatory variables included:
  - Lagged inflation term (captures persistence).
  - Output gap: () * , , t i t i yy − , in percent of potential GDP based on potential output derived from an HP filter applied to the maximum available length of the time series for each country.
  - Year-on-year growth rate of unit labor costs in the manufacturing sector: st ULC% − Δ.
  - Interactions of output gap and unit labor costs with trade openness ((exports plus imports)/GDP).
  - Year-on-year percent change in the trade-weighted nominal effective exchange rate against 41 partner countries: st NEER% − Δ.
  - Year-on-year VAT rate changes.
  - Initial (2001) price level relative to the EU-25 to capture catch-up effects.
- Lags: contemporaneous value and a one-year lag included for output gap, unit labor cost growth, and nominal effective exchange rate appreciation.

### Baseline regression: main findings for the eurozone (Table 1)
- Persistence:
  - Estimate of inflation persistence for the eurozone at about 80 percent.
  - Comparable estimates: Borio and Filardo (2007) 90 percent; Batini (2002) 70 percent; Rogers (forthcoming) just below 80 percent.
- Output gap and unit labor cost:
  - When the lagged inflation term is included, output gap and unit labor cost growth have expected positive signs but neither is significant at the conventional 5 percent level (column 1).
  - Interaction with trade openness: transmission from output gap and unit labor cost to domestic inflation is dampened by the degree of trade openness (columns 2 and 3).
  - Dampening influence is statistically more important for unit labor cost growth; at the mean value of trade openness, labor cost growth has a positive and significant relationship with domestic inflation.
- Role of lagged inflation term:
  - Removing the lagged term increases partial correlations between especially the output gap, but also unit labor cost and domestic inflation—suggesting persistence partly reflects transmission lags from output gap and unit labor cost (“inherited” inflation).
- Price-level catch-up:
  - Lower initial price level → higher subsequent inflation.
  - With lagged term removed, a country with a price level one-third below the EU average will experience an additional one percent a year in price inflation compared to the EU average.
  - Column 4 produces an estimate very close to Honohan and Lane (2003); Rogers (2002) also obtains a very similar estimate.
- Nominal effective exchange rate:
  - Expected negative sign; depreciation raises the inflation rate and is significant in specifications that include the lagged inflation term.
- Overall inflation regressions:
  - Findings for overall inflation are less informative; country-specific right-hand side variables are poorly correlated with overall inflation, since overall inflation is largely driven by common international sectoral and time trends.

### Non-eurozone comparisons and distinctions (Table 2)
- General: inflation in non-eurozone countries is driven by broadly similar features; the same model provides a good description of the inflationary process.
- Persistence: persistence coefficient about 80 percent, similar to the eurozone.
- Output gap:
  - For the noneurozone, the output gap is never statistically significant.
  - Possible reasons: these relatively open economies (ratio of trade to GDP is 0.87 outside the eurozone, relative to 0.74 inside) may transmit cyclical demand conditions less into domestic price movements; or output gap may be mismeasured in some new member states.
- Unit labor costs:
  - When lagged price level is included, interaction of unit labor cost growth with trade is negative and mildly significant; overall effect of rising wages at the mean level of trade openness is insignificant (unlike the eurozone, where it is positive and significant).
  - Removing the lagged term makes real wage growth more potent—suggesting structural factors and longer transmission lags in noneurozone countries.
- Nominal effective exchange rate:
  - Has a much greater quantitative influence in the noneurozone than in the eurozone.
- Initial price level coefficient:
  - In noneurozone, the coefficient on initial price level is smaller in magnitude than in the eurozone.
  - Catch-up speeds are similar for tradable goods in eurozone and noneurozone, but lower for non-tradable goods outside the eurozone, possibly due to insulation from cross-border effects.
  - Over time, as structural rigidities weaken, price catch-up is becoming a more important factor compared to unit labor costs in driving inflation persistence.

### Role of administrative/tax decisions (VAT)
- VAT rate changes raised inflation in both the eurozone and outside it.
- Quantitative details:
  - On average over the sample period, VAT rates changed by 0.32 percentage points outside the eurozone compared to 0.06 percentage points inside it.
  - Applying the two regression coefficients implies that, on average, VAT rate changes contributed 0.09 percentage points to inflation outside the eurozone compared to (text in source breaks off here).

*Source: Box 1 text, _wp07257 - Box 1: Defining Country-Specific Inflation*

### 0.03 percentage points inside it.

### _wp07257 - 0.03 percentage points inside it.

### Determinants of Country-Specific Inflation
- Country-specific component of inflation in the eurozone is influenced by:
  - the output gap,
  - rising labor costs (unit labor costs),
  - a tendency for mean reversion in price levels (price catch-up).
- External influences that matter:
  - Trade openness dampens the influence of rising labor costs.
  - A depreciation of the nominal effective exchange rate raises inflation.
- Outside the eurozone:
  - The country-specific component is more substantial.
  - Trade openness and especially the nominal effective exchange rate play an important role in determining inflation.
- Structural nature of domestic influences:
  - Domestic influences tend to be of a structural nature.
  - Lags in transmission of labor costs have been important on average during the full sample period.
  - Importance of labor-cost transmission has declined over time while the importance of the price catch-up factor has increased.
- Exact numeric mention: 0.03 percentage points (as stated in the unit title).

### Traded vs. Non-Traded Goods
- Eurozone:
  - The output gap has some cyclical (or contemporary) influence on inflation of traded-goods prices.
  - For both traded and non-traded goods, significant transmission lags are absorbed in the lagged inflation term.
  - The net effect of the output gap (when the lagged term is excluded) is of the same order of magnitude in both traded and non-traded sectors.
  - Price catch-up process has worked faster inside the eurozone than outside it for both traded and non-traded goods.
  - Catch-up is weaker in the non-traded goods sectors.
- Outside the eurozone:
  - The output gap does not appear to matter for traded or non-traded goods (in line with aggregate results).
  - Growth in unit labor cost is more of a factor outside the eurozone, with slow transmission lags that are part of inflation persistence.
  - Unit labor costs play more of a role in non-traded goods where competition forces are weaker; effect is somewhat greater outside the eurozone (consistent with Balassa-Samuelson effect), but the size of the effect is small.
  - The nominal effective exchange rate plays a much more important role outside the eurozone and does so through traded rather than non-traded goods.
  - The effect of VAT rate increases is stronger on non-traded goods.
- Interpretation:
  - Relative insulation of non-traded sectors may reflect local differentiation of services and difficulty of cross-border provision.
  - For non-eurozone countries, historic lower quality services supplied to lower-income populations may have limited price catch-up and allowed wage growth to translate into price increases.
  - With EU entry and globalization, this insulation may be eroding.

### Shifts Over Time
- Persistent and changing dynamics:
  - Influence of domestic output gap remained salient in the eurozone and may have increased in 2004/2005 relative to 2002/2003.
  - Effect of the nominal effective exchange rate decreased in importance inside the eurozone but increased outside, making differences starker.
  - Importance of unit labor costs modestly increased in the eurozone (mainly for non-traded goods) and declined outside, narrowing coefficient differences.
  - Price convergence effects increased in both eurozone and non-eurozone countries (for both traded and non-traded goods), implying faster price adjustments.
    - The price convergence effect rose from negligible in the first half of the sample to a more sizeable and statistically significant effect in the last two years of the sample (still smaller outside the eurozone than inside).
  - Effect of VAT rate changes declined over time both inside and outside the eurozone, for both traded and non-traded goods.
- Supporting numeric and contextual points:
  - The standard deviation of nominal effective appreciation across eurozone countries declined, on average, from 0.9 in the first half to 0.4 percent in the second half.

### Disinflation Episodes in Europe — Key Findings and Examples
- General observation:
  - Globalization reduces the country-specific component of inflation and dampens transmission of domestic demand to country-specific inflationary pressure.
  - Outside the eurozone, domestic demand (output gap or wage growth) has had limited influence on domestic inflation, reducing policymakers’ degrees of freedom to reduce inflation.
- Lithuania (case discussed):
  - Lithuanian inflation came within a whisker of falling below the Maastricht reference inflation rate.
  - Low inflation in 2002 and 2003 was partly due to wage restraint and largely due to an appreciation of its nominal effective exchange rate.
  - Price catch-up pressure is expected to make a significant contribution to Lithuania’s inflation rate going forward; variations in domestic output gap will play a modest role.
- Portugal:
  - 1995 stabilization: fiscal deficit fell from 7½ percent of GDP in 1994 to 3½ percent of GDP in 1997.
  - After EMU accession in 1999, money market rates declined to 1½ percent in real terms; fiscal stance represented a fiscal stimulus of ¼ percentage point of GDP per annum in the two years following accession.
  - Inflation rose above the Maastricht reference value by end-1998 and remained above it almost continuously until mid-2005.
  - Portugal in 1994: trade accounted for 57 percent of GDP; average in non-eurozone sample was 87 percent of GDP.
  - Greater openness in new EU members will dilute policy effort to contain inflation; several have relinquished monetary policy, increasing fiscal burden of disinflation.
- Spain:
  - Policy effort from about 1994: labor market reforms reduced restrictive practices and firing costs; unemployment declined and wage growth moderated.
  - Fiscal deficit cut by over 4 percentage points of GDP from 6½ percent of GDP in 1994 to 2¼ percent of GDP in 1997.
  - Maastricht inflation criterion met by January 1998; inflation rose again and remained above Maastricht criterion since mid-1999.
- Greece:
  - Inflation about 9 percent in mid-1990s; policy effort from 1995 to achieve EMU accession in 2000.
  - Money market rates raised to 9 percent in 1998; fiscal consolidation of almost 7 percentage points of GDP from 10¼ percent of GDP in 1995 to 3½ percent of GDP in 1999.
  - Inflation fell from 9 percent in 1995 to 2¼ percent in 1999; loosened policies after EMU accession led to inflation exceeding Maastricht reference within half a year and remaining above since.
- Ireland:
  - Fiscal reform in 1987: deficit declined from 9¼ percent of GDP in 1987 to 1½ percent of GDP in 1989; headline deficit in balance in 1996 and surplus in 1997–2001.
  - Real interest rates in excess of 5 percent until 1993; annual inflation fluctuated in the 2¼ - 3¼ percent range.
  - Inflation declined to 1½ percent in 1997; ECB policy loosening at EMU accession contributed to inflation rising above Maastricht reference by January 1999 and remaining above until mid-2005.
- Common pattern:
  - Rapid disinflation episodes in the EU have been associated with large fiscal adjustments, supported by monetary and structural policies.
  - For new member states, especially those that have relinquished monetary policy (e.g., Baltic nations), the burden on fiscal policy to achieve disinflation could be huge.
  - Structural reforms and continued increase in economic flexibility are necessary; no single structural measure is likely to be sufficient.

### Conclusions and Policy Implications
- Mechanisms linking globalization and inflation:
  - Globalization reduces scope for domestically-generated inflation via integrated product markets.
  - Globalization may break the link between domestic demand conditions and price setting as trading possibilities limit market power.
  - Country-specific inflation can be driven by price catch-up, a process largely outside policymakers’ control.
- Balassa-Samuelson and unit labor costs:
  - Unit labor cost growth is more potent in raising prices of non-traded goods than of traded goods.
  - This force is somewhat more prominent outside the eurozone.
- Price catch-up:
  - Catch-up has worked more slowly in non-traded sectors but has accelerated, including in non-traded goods, even in the short period covered by the study.
  - If price catch-up accelerates, policymakers will have limited leverage and may have little reason to oppose it; catch-up does not constitute the same kind of “inefficient” inflation as lack of policy credibility.
- Fiscal policy and disinflation:
  - Substantial fiscal consolidations may be needed to reduce inflation by significant margins.
  - Such consolidations may be difficult to sustain and therefore may only achieve temporary reductions in inflation.
- Overall implication:
  - Because of internationalization forces, domestic policies will have increasingly smaller scope in curbing inflation; the pace of structural change and continued integration will shape future inflation dynamics.

*Source: _wp07257 - 0.03 percentage points inside it.*

### Appendix Table. Data and Sources

### Appendix Table. Data and Sources

### Dependent variable and sample
- Decomposition into country-specific and virtual inflation: Monthly HICP index for January 2001−December 2005 (2005=100). For several commodities, some countries do not report data for either the whole time span or parts of it. If any part of a country-by-commodity series was missing, it was excluded from the sample.
- Panel regression dependent variable: Year-on-year log difference in the actual HICP minus year-on-year log difference in the virtual HICP.
- Source: Eurostat.

### Key independent variables (definitions and sources)
- Year-on-year growth in nominal unit labor cost in manufacturing (log differences, in percent). Nominal unit labor cost defined as gross wages and salaries in manufacturing per unit of the volume index of manufacturing production (working day adjusted). Data rebased to 2000=100. Data missing for Sweden and Malta (excluded from panel regressions). Source: Eurostat.
- Year-on-year nominal effective appreciation (log differences, in percent). Nominal effective exchange rate (1999=100) in 41 trading partners used. Source: Eurostat.
- Quarterly output gap (in percent of potential GDP). Potential GDP estimated using an HP filter on seasonally and working day adjusted (except Luxembourg) quarterly real GDP data from Q1 1996, or earliest available data after Q1 1996. Real GDP data in 1995 prices (except Latvia and Italy in 2000 prices) in national currency units. Source: Haver Analytics.
- Relative price level (EU25=1) in 2001 for household final consumption expenditure. Source: Eurostat.

### Control variables (definitions and sources)
- Four-quarter change in standard or reduced VAT rate, whichever was larger. Source: European Commission.
- Trade in percent of GDP lagged by four quarters. Exports and imports (in millions of euros) seasonally and working day adjusted in percent of GDP. Source: Eurostat.

### Missing-data detail (country-by-commodity missing series)
- The following data were missing: other service related to dwellings (Begium, Malta, Slovenia, Luxembourg, and the U.K.); water supply, refuse and sewage collection (Slovenia); liquid and solid fuels (Netherlands and Malta); repair of furniture, furnishings and floor coverings (Austria, Belgium, Estonia, Greece, Luxembourg, Malta, Spain, Slovenia, Sweden, and the U.K.); repair of household appliances (Latvia); domestic services and household services (Slovenia); hospital services (Estonia, Hungary, Slovenia, and the Slovak Republic); maintenance and repair of other major durables for recreation and culture (all but Ireland, Lithuania, Luxembourg, Netherlands, Portugal, and Sweden); major durables for indoor and outdoor recreation including musical instruments (Estonia, Spain, and Latvia); social protection (Estonia, Hungary, Latvia, and Lithuania); and other financial services (Cyprus).

### Selected regression results — Table 1 (Eurozone: Overall and Country-Specific Inflation)
- Dependent variable: Country-specific inflation / Overall inflation.
- Lagged dependent variable (reported values): 0.80, 0.80, 0.79, ... 0.74. Robust P-values: [0.00]***, [0.00]***, [0.00]***, ... [0.00]***.
- Cumulative coefficients (contemporaneous + 1-year lag):
  - Output gap: 0.09, 0.24, 0.09, 0.39, 0.04. F-test (Prob>F): [0.11], [0.04]**, [0.13], [0.00]***, [0.65].
  - NEER (nominal effective exchange rate): -0.04, -0.04, -0.04, 0.00, -0.01. F-test (Prob>F): [0.03]**, [0.02]**, [0.02]**, [0.97], [0.64].
  - ULC (unit labor cost): 0.02, 0.06, 0.06, 0.13, 0.04. F-test (Prob>F): [0.11], [0.00]***, [0.00]***, [0.00]***, [0.12].
  - ULC*trade interaction: ... -0.05, -0.05, -0.11, -0.03. F-test (Prob>F): ...[0.09]*, [0.07]*, [0.11], [0.49].
- Memorandum item ULC*trade+ULC: ... 0.02, 0.03, 0.05, 0.02. F-test (Prob>F): ...[0.10]*, [0.07]*, [0.09]*, [0.20].
- Observations: 179, 179, 179, 191, 179.
- Number of countries: 12, 12, 12, 12, 12.
- R-squared (within): 0.67, 0.68, 0.68, 0.25, 0.46.
- R-squared (between): 0.98, 0.98, 0.98, 0.64, 0.97.
- R-squared (overall): 0.85, 0.86, 0.86, 0.47, 0.73.
- Note: Robust P-values in brackets; *** ≤ 0.01; ** > 0.01 and ≤ 0.05; * > 0.05 and ≤ 0.10.

### Selected regression results — Table 2 (Non‑Eurozone: Country-Specific and Overall Inflation)
- Dependent variable: Country-specific inflation / Overall inflation (various non-eurozone groupings).
- Lagged dependent variable (reported values): 0.78, 0.78, 0.78, 0.78, ... 0.72. Robust P-values: [0.00]***.
- Cumulative coefficients (contemporaneous + 1-year lag):
  - Output gap: -0.07, 0.38, -0.06, -0.11, -0.05, -0.11. F-test (Prob>F): [0.43], [0.25], [0.46], [0.23], [0.66], [0.25].
  - NEER: -0.10, -0.11, -0.11, -0.14, -0.26, -0.12. F-test (Prob>F): [0.00]*** across reported columns.
  - ULC: 0.02, 0.11, 0.12, 0.16, 0.29, 0.12. F-test (Prob>F): [0.3], [0.11], [0.05]*, [0.04]**, [0.00]***, [0.09]*.
  - ULC*trade: ... -0.10, -0.13, -0.15, -0.09, -0.10. F-test (Prob>F): ...[0.2], [0.09]*, [0.06]*, [0.43], [0.17].
- Memorandum item ULC*trade+ULC: ... 0.02, 0.01, 0.01, 0.21, 0.03. F-test (Prob>F): ...[0.40], [0.51], [0.74], [0.00]***, [0.18].
- Observations: 165, 165, 165, 120, 176, 165.
- Number of countries: 11, 11, 11, 8, 11, 11.
- R-squared (within): 0.72, 0.73, 0.73, 0.78, 0.34, 0.67.
- R-squared (between): 0.98, 0.99, 0.99, 1.00, 0.91, 0.99.
- R-squared (overall): 0.86, 0.86, 0.86, 0.89, 0.62, 0.83.
- Note: Robust P-values in brackets; *** ≤ 0.01; ** > 0.01 and ≤ 0.05; * > 0.05 and ≤ 0.10.

### Selected regression results — Table 3 (Eurozone and Non‑Eurozone: Tradables vs Nontradables)
- Dependent variable: Country-specific year-on-year inflation in Nontradables and Tradables, Eurozone and Non-Eurozone.
- Example coefficients (cumulative contemporaneous + 1-year lag shown where reported):
  - NEER:
    - Eurozone Nontradables: -0.02 (F-test [0.27]).
    - Eurozone Tradables: 0.03 (F-test [0.49]).
    - Non-Eurozone Nontradables: -0.11 (F-test [0.00]***).
    - Non-Eurozone Tradables: -0.19 (F-test [0.00]***).
  - ULC:
    - Eurozone Nontradables: 0.05 (F-test [0.15]).
    - Eurozone Tradables: 0.09 (F-test [0.11]).
    - Non-Eurozone Nontradables: 0.14 (F-test [0.01]**).
    - Non-Eurozone Tradables: 0.17 (F-test [0.03]**).
  - ULC*trade:
    - Eurozone Tradables: -0.06 (F-test [0.59]).
    - Eurozone Nontradables: -0.02 (F-test [0.54]).
    - Non-Eurozone Tradables: -0.16 (F-test [0.24]).
- Memorandum item ULC*trade+ULC: reported values across columns (examples) 0.03, 0.05, 0.02, 0.04, 0.05, 0.23, 0.00, 0.20 with F-tests including [0.06]*, [0.29], [0.21], [0.10]*, [0.05]**, [0.00]***, [0.99], [0.00]***.
- Observations per column: 179, 191, 179, 191, 165, 176, 165, 176.
- Number of countries per column: 12, 12, 12, 12, 11, 11, 11, 11.
- R-squared (within) examples: 0.57, 0.19, 0.60, 0.14, 0.71, 0.35, 0.69, 0.28.
- Note: Robust P-values in brackets; *** ≤ 0.01; ** > 0.01 and ≤ 0.05; * > 0.05 and ≤ 0.10.

### Time-split results — Table 4 (2002/2003 vs 2004/2005)
- Results presented separately for 2002/2003 and 2004/2005 for Eurozone and Non-Eurozone, Tradables and Nontradables.
- Example highlights:
  - Trade lagged 1 year (share of GDP): coefficients vary over time and regime; examples include 0.01, 0.42, 0.68, 1.00, -0.26, 0.26, 0.25, 0.00 with p-values including [0.96], [0.06]*, [0.26], [0.00]***.
  - Relative price level in 2001 (EU25=1): large negative coefficients in several 2004/2005 columns (e.g., -2.89, -4.00) with p-values [0.00]***.
  - Maximum change in VAT rate over past year: positive and often significant coefficients (examples 0.47 [0.00]***; 1.07 [0.06]*; 0.39 [0.00]***).
  - Cumulative NEER and ULC effects vary by period and sector; p-values indicate significance in multiple columns.
- Observations and number of countries vary by column (examples: Observations 84, 96, 95, 95; Number of countries 12, 12, 12, 12).
- R-squared (overall) examples: 0.91, 0.43, 0.81, 0.61, 0.92, 0.69, 0.88, 0.75.

### Country case statistics and selected figures (figure captions and highlights)
- Figure 1: EU25 average commodity-specific inflation presented in log changes in price levels for many commodity categories separated into Tradables and Nontradables (categories listed in source).
- Figure 2: EU25 European business cycle inflation plotted with Oil price growth (right scale); additional panel with Industrial production volume growth (right scale).
- Figure 3: EU25 average country-specific inflation (year-on-year, in percent) by regional groups and average ratio of country-specific to overall year-on-year inflation (in absolute terms).
- Figure 4: EU25 share of variance of inflation explained by country-specific inflation (In percent) by regional groups.
- Figure 5: EU25 average country-specific inflation and relative price level (Year-on-year percent change 2002-2005, and EU25=100 in 2001) — axes include Relative price level and Inflation.
- Figure 6: Lithuania: Average Contribution to Excess Year-on-Year Inflation (In percentage points) — components shown include Relative price level, Nominal effective appreciation, Unit labor cost growth, Output gap, VAT rate changes, Inflation. Note: "Excess over sample average inflation."
- Figure 7: Portugal: Average Contribution to Excess Year-on-Year Inflation (In percentage points) — same component decomposition as Lithuania. Note: "Excess over sample average inflation."

### Selected country indicators in appendices (tables)
- Table 6. The EU's Southern Periphery: Selected Economic Indicators in the Runup to EMU Accession (examples for Spain, Portugal, Greece around accession assessment years):
  - Spain (t=1997) — Inflation (in percent) by quarter t−4 to t+2: 4.6, 4.7, 4.7, 3.5, 2.0, 1.8, 2.3. Real GDP growth (in percent): -1.0, 2.4, 2.8, 2.4, 3.8, 4.5, 4.7. Real unit labor cost (in percent): 0.8, -2.9, -2.1, -0.4, -1.4, 0.0, -0.5. Current account deficit (in percent of GDP): -1.1, -1.2, -0.3, -0.4, -0.1, -1.2, -2.9. Fiscal deficit (in percent of GDP) 2/: -6.6, -6.4, -5.0, -5.3, -2.3, -0.9, -1.2. Real money market rates (in percent): 7.4, 3.0, 4.1, 4.0, 3.4, 2.5, 0.4.
  - Portugal (t=1997) — Inflation (in percent): 6.4, 5.3, 4.2, 3.1, 1.8, 2.8, 2.3. Real GDP growth (in percent): -2.1, 0.9, 4.3, 3.6, 4.2, 4.7, 3.8. Real unit labor cost (in percent): -1.3, -3.5, -1.3, 1.0, -0.4, -0.5, 8.1. Current account deficit (in percent of GDP): 0.3, -2.3, -0.1, -4.2, -6.0, -7.1, -8.5. Fiscal deficit (in percent of GDP): -7.8, -7.4, -5.3, -4.6, -3.4, -3.0, -2.7. Real money market rates (in percent): 6.4, 5.1, 4.6, 4.2, 3.9, 1.5, 0.4.
  - Greece (t=1999) — Inflation (in percent): 8.9, 7.9, 5.4, 4.6, 2.2, 2.8, 3.7. Real GDP growth (in percent): 2.0, 2.4, 3.7, 3.3, 3.4, 4.5, 4.6. Real unit labor cost (in percent): 1.7, -1.4, 2.2, 0.8, 0.0, -2.0, -2.8. Current account deficit (in percent of GDP): -2.4, -3.7, -4.0, -3.0, -4.1, -8.6, -8.0. Fiscal deficit (in percent of GDP): -10.2, -7.4, -6.6, -4.3, -3.4, -4.1, -6.1. Real money market rates (in percent) 4/: 6.9, 5.5, 7.0, 9.0, 6.0, 3.3, 0.4.
  - Notes: 1/ EMU accession assessment year t = 1997 for Spain and Portugal (fiscal positions assessed for 1997, interest and inflation rates for 1998); EMU accession assessment year t = 1999 for Greece (fiscal positions assessed for 1999, interest and inflation rates for 2000). 2/ Based on national classification for 1993-1998 because not available in ESA95 terms until 1995. For 1999, in ESA95 terms because not available in national classification. 4/ Money market rates not available from 1999, hence use of treasury bill rates for t, t+1 and t+2.
- Table 7. Ireland: Selected Economic Indicators During Fiscal Consolidation Period, 1983-1989 (example series by year included in table).

*Source: Authors' calculations and compilation of Eurostat, Haver Analytics, European Commission, and IFS data as shown in the appendix tables and figures.*

### Bibliography

### _wp07257 - Bibliography

### Inflation dynamics and persistence
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- Ball, Laurence M., 2006, “Has Globalization Changed Inflation?” NBER Working Paper No. 12687.  
- Borio, Claudio, Andrew Filardo, 2007, “Globalization and Inflation: New Cross-Country Evidence on the New Global Determinants of Domestic Inflation,” BIS Working Paper No. 227.  
- Cristadoro, Riccardo, Lucrezia Reichlin, Mario Forni and Giovanni Veronese, 2005, “A Core Inflation Indicator for the Euro Area,” Journal of Money, Credit, and Banking vol. 37, no. 3, pp. 539-60.  
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- Gertler, Mark and John Leahy, 2006, “A Phillips Curve with an Ss Foundation,” NBER Working Paper 11971, January.  
- Honohan, Patrick and Philip R. Lane, 2003, “Divergent Inflation Rates in EMU,” Economic Policy, Vol. 37, pp. 359–94.  
- Mishkin, Frederic, 2007, “Inflation Dynamics,” NBER Working Paper No. 13147.  
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- Woodford, Michael, 1999, “Optimal Monetary Policy Inertia,” NBER Working Paper No. 7261.  
- Woodford, Michael, 2007, “Interpreting Inflation Persistence: Comments on the Conference on ‘Quantitative Evidence of Price Determination’,” Journal of Money, Credit, and Banking vol. 39, pp. 203-210.  

### Globalization, openness, and inflation
- Ball, Laurence M., 2006, “Has Globalization Changed Inflation?” NBER Working Paper No. 12687.  
- Ihrig, Jane, Steven B. Kamin, Deborah Lindner, and Jaime Marquez, 2007, “Some Simple Tests of the Globalization and Inflation Hypothesis,” Board of Governors of the Federal Reserve System Finance Discussion Paper No. 891.  
- Mankiw, Gregory, 2001, “The Inexorable and Mysterious Tradeoff between Inflation and Unemployment,” Economic Journal vol. 111, no. 471, pp. C45-61.  
- Mankiw, Gregory, and Ricardo Reis, 2002, “Sticky Information Versus Sticky Prices: A Proposal to Replace the New Keynesian Phillips Curve,” Quarterly Journal of Economics vol. 117, no. 4, pp. 1295-1328.  
- Mishkin, Frederic, 2007, “Inflation Dynamics,” NBER Working Paper No. 13147.  
- Razin, Assaf, 2004, “Aggregate Supply and Potential Output,” NBER Working Papers, no. 10294.  
- Razin, Assaf, and Alon Binyamini, 2007, “Flattened Inflation-Output Tradeoff and Enhanced Anti-Inflation Policy: Outcome of Globalization?” NBER Working Paper No. 13280.  
- Rogers, John H., 2002, “Monetary union, price level convergence, and inflation: how close is Europe to the United States?” International Finance Discussion Paper No. 740 2002, Board of Governors of the Federal Reserve System (U.S.).  
- Rogers, John H., forthcoming, “Monetary union, price level convergence, and inflation: how close is Europe to the United States?” Journal of Monetary Economics.  
- Rogoff, Kenneth, 2003, “Globalization and Global Disinflation,” Federal Reserve Bank of Kansas City Economic Review vol. 88, no. 4, pp. 45-78.  
- Rogoff, Kenneth, 2004, “Globalization and Global Disinflation,” in Federal Reserve Bank of Kansas, Monetary Policy and Uncertainty: Adapting to a Changing Economy, Papers and Proceedings of 2003 Jackson Hole Symposium.  
- Rogoff, Kenneth, 2006, “Impact of Globalization on Monetary Policy,” in Federal Reserve Bank of Kansas, Monetary Policy and Uncertainty: Adapting to a Changing Economy, Papers and Proceedings of 2003 Jackson Hole Symposium.  
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### EMU, accession countries, and price convergence
- Altissimo, Filippo; Pierpaolo Benigno; and Diego Rodrigues Palenzuela, 2005, “Long-Run Determinants of Inflation Differentials in a Monetary Union,” NBER Working Paper No. 11473.  
- Angeloni, Ignazio, and Michael Ehrmann, 2004, “Euro Area Inflation Differentials,” ECB Working Paper, No. 388 (Frankfurt: European Central Bank).  
- Artis, Michael J.; Massimiliano Marcellino; and Tommaso Proietti, 2004, “Characterizing the Business Cycle for Accession Countries,” CEPR Working Paper, no. 4457.  
- Baldwin, Richard and Daria Taglioni, 2006, “Gravities for Dummies and Dummies for Gravities,” NBER Working Paper No. 12516.  
- Balmaseda, Manuel, Miguel Sebastian, Patry Tello, 2002, “Spain Accession to the EMU: A Long and Hilly Road,” Economic and Social Review, vol. 33 no. 2, pp. 195-222.  
- Barry, Frank, 2003, “Economic Integration and Convergence Processes in the EU Cohesion Countries,” Journal of Common Market Studies, vol. 41 no. 5, pp. 897-921.  
- Boreiko, Dmitri, 2003, “EMU and Accession Countries: Fuzzy Cluster Analysis of Membership,” International Journal of Finance and Economics vol. 8, no. 4, pp. 309-25.  
- Buiter, Willem H., 2004, “To Purgatory and Beyond: When and How Should the Accession Countries from Central and Eastern Europe Become Full Members of the EMU?” CEPR Discussion Paper No. 4342.  
- Busetti, Fabio; Lorenzo Forni; Andrew Harvey; and Fabrizio Venditti, 2006, “Inflation Convergence and Divergence within the European Monetary Union,” ECB Working Paper No. 574.  
- Fidrmuc, Jarko and Iikka Korhonen, 2004, “The Euro goes East: Implications of the 2000-2002 Economic Slowdown for Synchronisation of Business Cycles between the Euro Area and CEECs,” Comparative Economic Studies, vol. 46, pp. 45-62.  
- Honohan, Patrick and Philip R. Lane, 2003, “Divergent Inflation Rates in EMU,” Economic Policy, Vol. 37, pp. 359–94.  
- Lane, Philip R., 2006, “The Real Effects of EMU,” IIS Discussion Paper No. 115.  
- Lazaretou, Sophia, 2005, “Greek Monetary Economics in Retrospect: The Adventures of the Drachma,” Economic Notes, vol. 34 no. 3, pp. 331-370.  
- Hurník, Jaromír; and Ales Bulir, 2006, “The Maastricht Inflation Criterion: How Unpleasant is Purgatory?” IMF Working Paper No. 06/154.  
- Detragiache, Enrica, Javier A. Hamann, 1999, “Exchange Rate-Based Stabilization in Western Europe: Greece, Ireland, Italy, and Portugal,” Contemporary Economic Policy, vol. 17 no. 3, pp. 358-69.  

### Price dispersion, measurement, and market integration
- Goldberg, Pinelopi Koujianou and Frank Verboven, 2001, “The Evolution of Price Dispersion in the European Car Market,” Review of Economic Studies, vol. 68, no. 4, pp.811-48.  
- Goldberg, Pinelopi Koujianou and Frank Verboven, 2005, “Market Integration and Convergence to the Law of One Price: Evidence from the European Car Market,” Journal of International Economics, vol. 65, no. 1, pp.49-73.  
- Hahn, Elke, 2002, “Core Inflation in the Euro Area: An Application of the Generalized Dynamic Factor Model,” CFS Working Paper No. 2002/11.  
- Hoffmann, Johannes, 1998, “Problems of Inflation Measurement in Germany,” Economic Research Group of the Deutsche Bundesbank, Discussion Paper No. 1/98.  
- Hanousek, Jan; and Randall K. Filer, 2004, “Consumers' Opinion of Inflation Bias Due to Quality Improvements,” Economic Development and Cultural Change, vol. 53, pp. 235–254.  

### Methods, common factors, and international co-movements
- Chen, Natalie, Jean Imbs, and Andrew Scott, 2006, “The Dynamics of Trade and Competition,” Lausanne: Ecole des Hautes Etudes Commerciales, mimeo.  
- Lumsdaine, Robin L. and Eswar S. Prasad, 2003, “Identifying the Common Component in International Economic Fluctuations,” Economic Journal vol. 113, pp. 101-27.  
- Marimon, Ramon, and Fabrizio Zilibotti, 1998, “‘Actual’ versus ‘virtual’ employment in Europe—Is Spain different?” European Economic Review, Vol. 42, pp. 123–53.  
- Stockman, Alan, 1998, “Sectoral and Aggregate National Disturbances to Industrial Output in Seven European Countries,” Journal of Monetary Economics vol. 21, pp. 387-409.  
- Chen, Natalie, Jean Imbs, and Andrew Scott, 2006, “The Dynamics of Trade and Competition,” Lausanne: Ecole des Hautes Etudes Commerciales, mimeo.  

### Labor markets, productivity, and structural issues
- Bover, Olympia, Pilar Garcia-Perea, Pedro Portugal, 2000, “Labor Market Outliers: Lessons from Portugal and Spain,” Economic Policy, vol. 15 no. 31, pp. 379-428.  
- Linde, Jesper, 2005, “The Effects of Permanent Technology Shocks on Labour Productivity and Hours in the RBC Model,” CEPR Discussion Papers, no. 4827.  
- Marimon, Ramon, and Fabrizio Zilibotti, 1998, “‘Actual’ versus ‘virtual’ employment in Europe—Is Spain different?” European Economic Review, Vol. 42, pp. 123–53.  
- Gutierrez, Eva, 2003, “Inflation Performance and Constitutional Central Bank Independence: Evidence from Latin America and the Caribbean,” IMF Working Paper No. 03/53.  
- Daniels, Joseph P. and David VanHoose, 2006, “Openness, the sacrifice ratio, and inflation: Is there a puzzle?” Journal of International Money and Finance, vol. 25, no. 8, pp. 1336-1347.  

*Source: _wp07257 - Bibliography (PDF chapter/section).*

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