Abstract
The literature on optimum currency areas states that large inflation differentials can undermine monetary union. In the euro area, inflation rates diverged after the creation of the single currency, but started to converge again from mid-2002. Against this background, we assess the convergence of inflation rates and business cycles and study the relationship between them. The analysis is made using an unobserved component model estimated with the Kalman filter. In general, from 1980 to 2008 inflation rates and business cycles became more aligned in the euro area, but inflation rates converged more quickly than business cycles. The output gap is found to be a better indicator of the business cycle than unit labour cost when studying convergence. By looking at the causality between the convergence of inflation and output gap, it is found that inflation divergence has a limited destabilising economic impact.
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Notes
In the empirical results of this paper, euro area refers only to 12 countries, the original 11 plus Greece.
In the New Keynesian Phillips Curve the driver of inflation is the marginal cost, which can be measured using the labour income share, also called real unit labour cost.
They are optimal in the sense that they minimise the Mean Squared Error.
π i,t : quarterly inflation rate annualised: (1 + inf quarterly t )4−1, where inf quarterly t =p t /p t − 1 − 1, with p as the CPI.
Note that with ϕ >1 the model is explosive.
Consequently, the z-statistics critical value at 5 % significance for rejecting the null hypothesis (using a one-sided test: H 0 : ϕ = 1 vs H 0 : ϕ < 1) should be (in absolute value) between 2.71 (=1.65*1.645) and 3.29 (=2*1.645).
The filtered value of α t is computed as follows. Firstly, the one-step ahead forecast for period t is obtained using information until t-1. The filtered state of α t corresponds to the update of this forecast using information up to t.
The nominal ULC series excludes also the irregular movements in the underlying series. Moreover, since the ULC of the entire economy was not available for Portugal, we used the ULC of the business sector.
Regarding this test, it is worth noting that as a Wald test is asymptotically equivalent to a likelihood ratio test, the null hypothesis tests more than whether the variance is zero in the last period. In fact, it tests whether a full path of convergence exists, leading to a zero variance in the last period.
Notice that for the growth rates of the nominal ULC we are not interested in studying if there is convergence in expectation, because that is already ensured as these variables are stationary. Instead, our main goal is to understand how the variance of these variables evolves over time. As a result, we can use the standard critical value 1.675 for a one-sided test at 5 % significance.
Once more, we are not interested in studying if there is convergence in expectation because that is already ensured as output gaps are stationary variables.
In this test we use the standard critical values to test H0: ϕ=1, because the difference of output gaps is stationary even if H0 is not rejected.
The convergence rate is Ω t /Ω t − 1 − 1 = ϕ − 1.
We use a two-sided test because both ϕ z < 1 and ϕ z > 1 are plausible alternative hypotheses.
For Austria, Germany and Portugal, the significance is at a 10 % level.
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Acknowledgments
We are grateful to Kevin Lee, Simon Wren-Lewis, the anonymous referees and George S. Tavlas (the Editor-in-Chief) for helpful comments and suggestions. The usual disclaimer applies. Sérgio Lagoa thanks the financial support of Fundação para a Ciência e Tecnologia, scholarship SFRH/BD/27973/2006.
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Hall, S.G., Lagoa, S. Inflation and Business Cycle Convergence in the Euro Area: Empirical Analysis Using an Unobserved Component Model. Open Econ Rev 25, 885–908 (2014). https://doi.org/10.1007/s11079-014-9313-0
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DOI: https://doi.org/10.1007/s11079-014-9313-0