Inflation Differentials in the EU: A Common (Factors) Approach with Implications for EU8 Euro Adoption Prospects
IMF Working Papers, January 1, 2008
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- Inflation Differentials in the EU: A Common (Factors) Approach with Implications for EU8 Euro Adoption Prospects
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Bibliographic details
- Published: January 1, 2008
- Series: IMF Working Papers
- DOI: https://doi.org/10.5089/9781451868838.001
Summary
- This paper explores inflation determinants within the EU and implications for new members' euro adoption plans.
- Factor analysis partitions observed inflation in EU25 countries into common-origin and country-specific (idiosyncratic) components.
- Cross-country differences in common-origin inflation within the EU are found to depend on:
- gaps in the initial price level,
- changes in the nominal effective exchange rate,
- the quality of institutions,
- the economy's flexibility.
- Idiosyncratic inflation is generally small in magnitude.
- Country-specific shocks have systematically pushed down headline inflation, potentially influencing the assessment of compliance with the Maastricht inflation criterion.
Key Findings
- Inflation in EU25 countries can be decomposed into common-origin and idiosyncratic components via factor analysis.
- Cross-country variation in the common-origin component is associated with:
- initial price level gaps,
- nominal effective exchange rate changes,
- institutional quality,
- labor market and broader economic flexibility.
- The idiosyncratic (country-specific) component is small but has exerted a downward effect on headline inflation in affected countries, with implications for meeting the Maastricht inflation criterion.
Methodology
- Empirical approach: factor analysis applied to inflation series for EU25 countries to separate common-origin and idiosyncratic components.
Policy Implications and Relevance for EU8 Euro Adoption
- Assessments of Maastricht inflation criterion compliance should account for the decomposition between common-origin and idiosyncratic inflation components because country-specific shocks can bias headline inflation downward.
- Consideration of initial price level gaps, nominal effective exchange rate developments, institutional quality, and economic flexibility is important when evaluating inflation differentials and the timing of euro adoption for new members.
- Implicit recommendation: policies that improve institutional quality and economic flexibility, and that monitor exchange rate developments, can influence the common-origin inflation path relevant for euro adoption decisions.
Content in this bundle
- _wp0821 - Appendix II. Data Definitions and Series