economy that has been outperforming the average in terms of cost competitiveness in order to progressively adjust towards a more normal level in line with the average. this problem had been observed, for instance, in the case of the netherlands and is possibly still relevant for ireland. third, inflation differentials are not only the necessary means of achieving relative price adjustments within the euro area, like in the case of germany, but they are also a natural feature of the euro area in view of the gradual convergence or catching - up process regarding gdp per - capita. fourth, there is one case where persistent inflation differentials are not advisable in terms of national economic policies : this is when an economy having an already relatively low level of cost competitiveness continues to face further deterioration due to higher inflation. in that case additional attention must be given to increasing the flexibility and adaptability of both institutions and market structures in the national economy concerned in order for the appropriate adjustment mechanism to function. sectoral specialisation in the euro area an interesting issue that has been touched upon in the last two days is whether the european integration process will result in higher sectoral specialisation across countries. as mentioned above, this is potentially important because a higher degree of specialisation might imply a greater vulnerability to asymmetric shocks and a greater need for relative price adjustments. as to the relevance of this argument, there are two lines of reasoning in the economic literature. the first, supported by krugman ( 1991, 1993 ) and the new economic geography models, suggests that, as trade barriers are reduced, inter - industry trade increases and opportunities for exploiting economies of scale and specialisation in production should arise whenever countries have a comparative advantage. consequently, countries ’ production structures would become less diversified and thus increasingly vulnerable to asymmetric shocks while business cycles would become less synchronised. the second, and opposite, line of reasoning, developed by frankel and rose ( 1998 ), suggests that european integration would instead lead to greater intra - industry trade integration and more similar economic structures. in this case, business cycles would become more strongly synchronised through the convergence of factor endowments and technology, as well as reduced exchange rate variability, which otherwise would tend to weaken intra - industry trade. the evidence on whether emu has favoured or prevented specialisation in the euro area is not clear yet. according to an overview published by the european commission, there have so far only been modest changes in the pattern of industrial concentration

in the euro area. in this context, i shall address the issue of inflation differentials within the area, in particular their size and recent evolution. i shall then focus on two particular issues. first, it has been argued that monetary union may contribute to a larger specialisation in production in the euro area. in this case, the need for relative price adjustments and inflation differentials to deal with sectoral developments may increase. i will briefly discuss the current evidence on sectoral specialisation. second, i will elaborate on the function of the inflation differentials and emphasize the importance of monitoring relative unit labour cost. inflation convergence in the euro area let me remind you that in the run - up to the formation of emu, the dispersion of national inflation rates has been lastingly reduced. in 1992 the difference between the highest and lowest inflation rate in terms of hipc across the euro area countries was 13. 5 percentage points. the dispersion steadily declined throughout the 90s, triggered by the preparations for emu, and broadly stabilised at the beginning of stage three of emu at around 3. 3 percentage points. since then, with the exception of a modest increase over the period 2000 - 02, the level of inflation dispersion across the euro area has changed very little, with the average standard deviation of inflation differentials being around 1. current inflation differentials within the euro area are not unusually large. rather, their magnitude is similar to those differentials seen in the united states among the 14 us metropolitan statistical areas, namely 3. 2 percentage points, with an average standard deviation of about 0. 9. it should be emphasised that in a monetary union inflation differentials across regions or countries are the natural way of adjusting relative prices in the face of asymmetric demand or supply developments. i would like to make 4 remarks in this respect. first, changes in relative prices within the single currency area have been larger and more frequent than anticipated. the idea that the euro area is an area where the single currency prevents adjustment of relative prices is clearly refuted. for instance, the capacity of the german economy to catch up rapidly with the average of the euro area in terms of cost competitiveness after the loss of competitiveness associated with german reunification is very impressive. from that viewpoint the euro area is more flexible and adaptable than had been anticipated by many observers. second, the previous process is symmetric. in some cases the existence of inflation differentials is the natural consequence for an