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Open Economies Review

, Volume 22, Issue 2, pp 189–233 | Cite as

Inflation Differentials in a Currency Area: Facts, Explanations and Policy

  • Filippo Altissimo
  • Pierpaolo BenignoEmail author
  • Diego Rodriguez Palenzuela
Article

Abstract

The determinants of inflation differentials in a currency area are analyzed both from an empirical and a theoretical perspective. The empirical analysis shows that a sizeable dispersion of HICP inflation rates across euro-area countries arises mostly in the components based on non-traded goods. There is also a significant cross-country heterogeneity in the response to changes in a common latent factor which accounts for a large fraction of the dispersion in national inflation rates. A stylized model of a currency area is used to understand the interrelation among shocks, structures and policies in driving the data generating process. The model shows that the dynamic of the inflation differentials is largely driven by the variability of productivity in the non-tradable sector of the more flexible economy. Conversely, the output differentials is largely driven by the variability in the productivity of the tradable sector, also of the more flexible economy. Optimal policy is investigated together with an analysis of the optimal adjustment to adopting a common currency with initial incorrect real exchange rate parity.

Keywords

Inflation dynamics Monetary union Price dispersion 

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Copyright information

© Springer Science+Business Media, LLC 2010

Authors and Affiliations

  • Filippo Altissimo
    • 1
  • Pierpaolo Benigno
    • 2
    • 3
    Email author
  • Diego Rodriguez Palenzuela
    • 4
  1. 1.Brevan Howard AM LLPLondonUK
  2. 2.LUISS Guido CarliRomaItaly
  3. 3.EIEFRomaItaly
  4. 4.European Central BankFrankfurt am MainGermany

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