EMU enlargement and convergence of price levels: Lessons from the German reunification

We analyse the possible impact of EMU enlargement on inflation rates in the accession countries. Using a simple theoretical model we show that the optimal path price adjustments should be asymmetric, i.e. occuring mostly in the candidate countries. Using data from the German reunification we examine how price level convergence could come about. These findings are applied to the enlargement EMU: our findings indicate that (trend) inflation rates in the EMU candidate countries are likely to increase sharply, whereas the impact on the current euro area likely to be small, albeit not negligible. Our results support the need to allow some flexibility in the exchange rate arrangements with the candidate countries facilitate gradual price level convergence prior to EMU enlargement.