Implications of the conversion of prices into euro for inflation

As is well known, 1 January 1999 marked the start of Stage Three of Economic and Monetary Union and the euro became the common currency of a group of eleven European countries, now twelve, of which Spain is one. However, money in circulation has continued to consist of the notes and coins of the pre-existing national currencies. Therefore, although the euro is now, and has been for almost three years, the common currency of the euro area, and the single monetary policy, implemented by the Eurosystem, determines the common monetary conditions for the area as a whole, most consumer prices continue to be denominated in the various national currencies, even though the practice of dual labelling has spread very rapidly. The introduction of euro banknotes and coins on 1 January 2002 constitutes the culmination of the process of monetary union that commenced with the signing of the Maastricht Treaty in 1992. Following two months of co-existence with the national currencies, the euro will be the only legal-tender currency in circulation, although it will still be possible to exchange peseta banknotes and coins until 30 June and, thereafter, at the Banco de España. The shared use of the same currency in different countries of the Union will bring the euro close to the people and enable them to identify more strongly with this common project. From this viewpoint, the introduction of the euro is another necessary step to harness the benefits of Monetary Union and in particular to obtain a greater degree of transparency and integration between the markets of the economies of the area. The greater competition between the firms that operate in these markets and the lower transaction and information costs facing them will help to reduce price pressures and to entrench a lower level of inflation. Obviously the introduction of the euro requires the immediate conversion of prices that have until now been denominated in pesetas (and other national currencies) into prices denominated in euro. The conversion operation is a simple algebraic transformation which, if done using a sufficient number of decimal places and a strict rounding rule, cannot have significant effects on the general price level and even less on the dynamics of inflation. This is the aim of the law on the implementation of the euro (Law 46/1998) which provides that when prices in pesetas are converted into euro by applying the irrevocable conversion rate (ESP 166.386/euro), they shall be rounded up or down to the nearest cent, so that for each price in pesetas there is only one legally equivalent price in euro. Furthermore, Law 91/2001 provides that the conversion into euro of unit rates, prices or duties to be applied to a particular base (which are normally small amounts as, for example, in the case of telephone and electricity rates) must be up or down to the nearest sixth decimal place. Even if the rules for conversion and rounding are properly applied, the price revisions that arise continuously during the normal course of economic activity may be affected by the extraordinary nature of the conversion process. It is therefore necessary to analyse the factors that may potentially affect price revisions at the time of conversion, and to evaluate their possible impact on the general price level and on the short-term behaviour of inflation. First to be mentioned, among these factors, are the costs for firms involved in making the necessary adjustment to the new currency, in areas as diverse as accounting, the conversion of labelling, the adaptation of machinery (vending machines, ATMs, cash registers, etc.), and even personnel training, which they may pass through to their final selling prices. Second, it is a well known fact that firms do not update the prices of their products continuously, but rather every so often, or when market circumstances are favourable. This is because there are certain costs involved in changing prices, known as “menu costs”, which range from changing labels (as in the case of a restaurant menu, which is the origin of the name of this theory) to the cost of obtaining the necessary information to set the correct price. It is possible that, since these menu costs will be unavoidably incurred when prices are converted into euro, firms will tend to concentrate at the time of conversion a number of price changes which, had this process not taken place, would have been made sooner or later. Third and last, it should be taken into account that many firms attempt to ensure that the prices they set have features that make them attractive to consumers. It should be noted that, were they to arise, the possible impact these factors might have on the rate of inflation would be temporary, since they would only affect prices for a short period of time. Moreover, there is no reason why the hypothetical pass-through of the costs of adapting to the euro to prices, or the conversion to euro itself, or the adjustment to attractive prices must necessarily take place on 1 January 2002. In fact, this date hardly seems the most propitious, since greater vigilance can be expected at that time due to the changeover. Firms have already been adjusting to the euro for some time, so that the pass-through of the costs they may have incurred is probably taking place already, and the available estimates indicate that this effect will in any case be moderate. Furthermore, dual labelling limits the scope for revising prices at the time of conversion. In principle, the process of converting prices to euro, whether merely by rounding to the nearest euro cent, or with the ultimate aim of setting attractive prices, is in itself, a neutral process as far as the rate of inflation is concerned. This article will demonstrate this fact, by describing various simulations that have been carried out using two different sets of prices, in which it is seen that, provided adjustments are symmetric, the effect on the price level (approximated by the CPI) is close to zero. Only if all suppliers of consumer products should decide to adjust their prices upwards (which is rather unlikely) would significant – albeit moderate – effects on inflation be observed. General asymmetric upward adjustment of prices is severely limited by competitive market forces, and this constraint is all the more powerful when the economy is slowing and the trend of inflation is downwards. Before considering the simulations, the next section discusses the reasons for the extensive use of so-called “attractive” prices in the economy. Section 3 then analyses the results of such simulations, under alternative scenarios for the adjustment of prices in pesetas to prices in euro, using two price samples. The conclusions are presented in Section 4.