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Is There Scope for Inflation Differentials in EMU? An Empirical Evaluation of the Balassa-Samuelson Model in EMU Countries

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  • Alberola, Enrique
  • Tyrväinen, Timo

Abstract

The Balassa-Samuelson (BS) model is evaluated in eight of the eleven EMU countries. This model suggests that productivity differentials between traded and non-traded goods sectors generate sectoral inflation differentials (dual inflation). Furthermore, differentials in the degree of dual inflation induce inflation differentials between countries. The standard BS model implies a cointegration relationship between relative prices and sectoral productivities. While this link generally seems to exist, the magnitudes of the parameter estimates are not in accordance with the theoretical model in most countries. As the presumed uniformity of sectoral wages is rejected in most cases, relative wages were allowed to enter the estimation. This extended BS model is endorsed by the data in every country. Simulations based on these results were carried out to quantify possible inflation differentials. Setting EMU-wide inflation equal to 2 per cent and assuming that PPP holds for traded goods, the projected inflation varies around the EMU-average within a margin of some +/-1 percentage points across the countries.

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Bibliographic Info

Paper provided by Bank of Finland in its series Research Discussion Papers with number 15/1998.

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Length: 46 pages
Date of creation: 20 Jul 1998
Date of revision:
Handle: RePEc:hhs:bofrdp:1998_015

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Postal: Bank of Finland, P.O. Box 160, FI-00101 Helsinki, Finland
Web page: http://www.suomenpankki.fi/en/
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Keywords: sectoral productivity; inflation differentials; EMU;

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  1. Jose De Gregorio & Alberto Giovannini & Holger C. Wolf, 1993. "International Evidence on Tradables and Nontradables Inflation," Working Papers 93-17, New York University, Leonard N. Stern School of Business, Department of Economics.
  2. Granger, Clive W J, 1986. "Developments in the Study of Cointegrated Economic Variables," Oxford Bulletin of Economics and Statistics, Department of Economics, University of Oxford, vol. 48(3), pages 213-28, August.
  3. Stephen Cecchetti & Nelson C. Mark & Robert Sonora, 1998. "Price Level Convergence Among United States Cities: Lessons for the European Central Bank," Working Papers 32, Oesterreichische Nationalbank (Austrian Central Bank).
  4. Johansen, Soren, 1992. "Testing weak exogeneity and the order of cointegration in UK money demand data," Journal of Policy Modeling, Elsevier, vol. 14(3), pages 313-334, June.
  5. Johansen, Soren & Juselius, Katarina, 1994. "Identification of the long-run and the short-run structure an application to the ISLM model," Journal of Econometrics, Elsevier, vol. 63(1), pages 7-36, July.
  6. Ronald Mac Donald, 1998. "What Do We Really Know About Real Exchange Rates?," Working Papers 28, Oesterreichische Nationalbank (Austrian Central Bank).
  7. S. Micossi & Gian-Maria Milesi-Ferretti, 1994. "Real Exchange Rates and the Prices of Nontradable Goods," IMF Working Papers 94/19, International Monetary Fund.
  8. Dirk Pilat, 1996. "Labour Productivity Levels in OECD Countries: Estimates for Manufacturing and Selected Service Sectors," OECD Economics Department Working Papers 169, OECD Publishing.
  9. Matthew Canzoneri & Robert Cumby & Behzad Diba & Gwen Eudey, 1998. "Trends in European Productivity: Implications for Real Exchange Rates, Real Interest Rates and Inflation Differentials," Working Papers 27, Oesterreichische Nationalbank (Austrian Central Bank).
  10. Johansen, Soren, 1991. "Estimation and Hypothesis Testing of Cointegration Vectors in Gaussian Vector Autoregressive Models," Econometrica, Econometric Society, vol. 59(6), pages 1551-80, November.
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