WRITTEN QUESTION E-0510/00

by Christopher Huhne (ELDR) to the Commission

(28 February 2000)

Subject: Studies of inflation differentials

In the light of the answer to Written Question E-2228/99(1), is the Commission aware of the studies undertaken by academics and market participants into the sustainable inflation differentials of each Member State in the eurozone? Would the Commission please list for each Member State the inflation differentials which different studies undertaken by academics and market participants have suggested would be sustainable?

(1) OJ C 219 E, 1.8.2000, p. 127.

Answer given by Mr Solbes Mira on behalf of the Commission

(4 April 2000)

Academic studies trying to assess the scope for sustainable inflation differentials in Economic and monetary union (EMU) include Alberola and Tyrväinen (1998), and Canzoneri et. al. (1998). These studies rely on the so-called Balassa-Samuelson model or an amended version thereof. The International monetary fund has also attempted a cross-country quantification of the Balassa-Samuelson effect in several recent reports. Market participants tend either to refer to these studies or to refer to the historical experience of some existing monetary unions, notably the United States or the United Kingdom. The European central bank (ECB) analysed the issue of inflation differentials in a monetary union in its monthly bulletin of October 1999.

The simulated sustainable inflation rates in the academic studies are given in a table sent direct to the Honourable Member and to Parliament's Secretariat. The simulations rely on three basic assumptions: (i) long-run purchasing power parity (PPP) will hold for tradeables in the euro area; (ii) the productivity growth differential between tradeables and non-tradeables will remain the same in EMU in each country as in the historical period; and (iii) prices in each sector will evolve in line with unit labour costs. Alberola and Tyrväinen allow for differences in sectoral wage trends in what they call an extended Balassa-Samuelson model.

These numerical exercises are valuable in showing that sustained inflation differentials in EMU may be justified. This fact needs to be recognised in the multilateral surveillance process and in the economic policies of euro area participants.

The simulations should not be viewed as accurate predictions of future long-term differences in inflation across EMU. The role of traded goods productivity bias in explaining real exchange rates across industrialised countries is still a matter of debate in the economic literature (cf. Rogoff (1996)). In the experience of EMU countries, national price levels measured in common currency have diverged by considerably less over long periods than the above simulations suggest. The assumptions underlying the simulations de facto have not been fulfilled (and need not be so in future), for example long-run PPP for traded goods has not been satisfied for all countries in the sample (cf. Canzoneri et.al. (1998)); the relative price of non-tradeables has risen generally less fast than indicated by relative productivity trends (cf. Canzoneri et.al. (1998)); productivity differentials between sectors may change over time (the remaining scope for catching-up in e.g. Italy and Spain is smaller today than in the early 1970s).

Experience from other monetary unions may help to shed light on the issue of inflation differentials in EMU. From 1950 to 1978 (when the Irish pound ceased to be linked to the British pound), the average difference in annual consumer price index (CPI) inflation between Ireland and the United Kingdom (countries with a considerable difference in the level of economic development at the time) was 0,4 %. Between Luxembourg and Belgium, the average difference over the period 1950-1988 was about 0,3 % per annum.

The Commission views the above mechanical simulations as upper limits on the likely scope for sustained inflation divergence in EMU. Nevertheless, in the economic management of the euro area it is very important to recognise that persistent inflation differences may be warranted in view of longer-term structural forces. The Commission welcomes the Parliament's interest in this important topic and would be glad to discuss further these issues with the Honourable Member.