A European Disease? Non-tradable Inflation and Real Interest Rate Divergence

This article studies the contribution of real interest rate divergence to the dynamics of the relative price of non-tradables within Europe. Extending the traditional Balassa–Samueslon effect, it shows that the real interest rate fall in the Euro area (EA) periphery following the single currency’s inception induced an increase in the relative price of non-tradable goods. Using a new data set, it documents the dynamics of the tradable and the non-tradable sectors over 1995–2013 and the expansion of the non-tradable sector in the periphery before the crisis. It then carries out an econometric estimation for 11 EA countries over 1995–2013 and quantifies the contribution of the pure Balassa–Samuelson effect and the impact of the interest rate on non-tradable relative prices. Diverging evolution in the interest rate impacted greatly the evolution of non-tradable relative prices within the EA over the period. In Greece, the fall in the real interest rate over 1995–2008 could explain almost half of the non-tradable price increase relative to the EA average, while in Germany the increase in the real interest rate might have contributed up to 7% of the decrease of the non-tradable price relative to the average of the EA. (JEL codes: F41, F45, E43).