Nonlinearity and Inflation Rate Differential Persistence: Evidence from the Eurozone.

Nonlinearity and Inflation Rate Differential Persistence: Evidence from the Eurozone.

We employ a linear unit root test as well as a nonlinear two-regime Threshold Autoregressive (TAR) unit root test to determine whether inflation differentials in the Eurozone during the period 1970-2009 were persistent or transitory.

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It is widely accepted that a monetary union should be characterized, among other factors, by the symmetric response to shocks across country-members. The condition of symmetric response holds if a specific economic disturbance has the same effect on all members of the monetary union. Of course, this condition will be satisfied only if national fiscal policies are synchronized and consistent with the targets of the common monetary policy. In the case of the European Economic and Monetary Union (EMU), the main aim of the common monetary policy is the achievement and maintenance of price stability and the promotion of macroeconomic stability in general. This is reflected by the inflation rate Maastricht convergence criterion, which states that each member’s inflation rate should not increase by more than 1.5% of the average inflation rate of the three members with the lowest inflation rate. This statement has a dual meaning. First, inflation rates in the Eurozone should be maintained at low levels and second, national inflation rates should not significantly diverge from each other. Indeed, inflation rate convergence increased in the 1990’s, but since the creation of the EMU, inflation rate differentials have increased, thereby implying signs of asymmetries in the Eurozone.

In the absence of real convergence among EMU members, prices may be different across countries because of income inequality and different GDP growth rates. Egert (2007) argues that prices in poorer countries are lower and that fast- growing economies have higher inflation rates. Since these differences would be reflected by the real exchange rate, the competitiveness of high-inflationary countries would remain unaffected. However, in a monetary union such as the EMU, where countries share the same currency, such differences are reflected by inflation rate differentials. The presence of different inflation rates among EMU members leads to negative consequences for the common monetary policy and the EMU as a whole. Specifically, persistent inflation differentials induce internal and external asymmetries in the Eurozone.

Internal asymmetry represents different growth opportunities that EMU members face. While the common monetary policy sets the same nominal interest rate for all EMU members, the presence of different inflation rates entails different real interest rates for the countries of the monetary union. Hence, depending on the inflation rate benchmark, the economies of the countries with lower inflation rates than the EMU (benchmark) inflation rate are weakened by relatively higher real interest rates. In contrast, the economies of the countries with higher inflation rates than the EMU inflation rate are strengthened by relatively lower real interest rates. Similarly, external asymmetry describes the situation in which different inflation rates across EMU members imply different competitive strengths of domestic economies in international trade. In a monetary union, countries with persistently higher inflation rates face a loss of competitiveness because movements in inflation differentials cannot be corrected by exchange rate adjustments.

In fact, the effect of an inflation rate differential on the Eurozone depends on the origin of the differential itself. In general, inflation rate differentials may originate from (a) supply-side factors such as the Ballassa–Samuelson effect (1964) (henceforth, BS effect); (b) demand-side factors, that is, higher income elasticity of non-traded goods; (c) external factors such as the oil price and exchange rate; and (d) structural factors, that is, price level convergence as a part of the inflation catching-up process. MacDonald & Wojcik (2008) argued that if inflation rate differentials arise from the BS effect, then these differentials can be considered as an equilibrium productivity-driven phenomenon. Moreover, Katsimi (2004) has argued that if inflation differential is due to the catching-up process (i.e., some countries experience rapid economic growth to fulfill real convergence in the monetary union), a higher inflation rate is reflected to higher productivity and therefore, competitiveness remains unaffected. As a consequence, inflation differentials disappear when real convergence is achieved and economic asymmetries in the Eurozone will gradually diminish as well.

The present study aims to determine whether or not inflation rate differentials in the Eurozone are persistent, or, in other words, whether or not inflation rate convergence exists among the 16 country-members. Previous studies have tested inflation rate convergence and inflation rate differential persistence by stationarity and cointegration techniques. The evidence of stationarity of inflation differentials implies that any differences between inflation rates are only transitory. Similarly, the presence of cointegration among inflation rates implies that they follow a common long-run trend. Empirical studies apply time series analyses (see among others, Koedijk & Kool, 1992; Siklos & Wohar, 1997; Rodriquez-Fuentes et al., 2004; Busetti et al., 2007) and panel data techniques (see among others, Kocenda & Papell, 1997; Holmes, 2002; Beck & Weber, 2005). A majority of the above studies argue that inflation rate differentials were transitory during the pre-EMU period. However, these studies have not taken into account the fact that inflation rate differentials may exhibit nonlinear instead of linear behavior. This gap in the literature has been filled by Arghyrou et al. (2005) and Gregoriou & Kontonikas (2006, 2009), who have demonstrated that inflation differentials follow a nonlinear mean reverting process. Employing the framework of Smooth Transition Autoregressive (STAR) models, these studies argue that the greater the inflation differential, the higher is the speed of adjustment toward the benchmark inflation rate.

In the present study, we apply a nonlinear two-regime Threshold Autoregressive (TAR) unit root test, developed by Caner & Hansen (2001), to determine whether inflation differentials in the Eurozone during the period 1970–2009 were persistent or transitory. We model three types of inflation rate differentials according to the selected inflation rate benchmark. The first type is the difference between each member’s inflation rate and the French inflation rate. Similarly, the second type is the difference between each member’s inflation rate and the German inflation rate. Finally, the third type is the difference between each member’s inflation rate and the euro area’s inflation rate.

Our paper contributes to the literature by providing evidence based on long-term data that includes the post-EMU period. While the empirical literature on inflation rate differentials is fairly rich, previous studies have mainly provided evidence for the pre-EMU period. To our knowledge, the present study is one of the few works that focus on EMU by using data for the post-EMU period. A salient feature of this study is that unlike other studies, it uses the most recent data, and therefore provides a clearer view of the stochastic properties of inflation differentials in the Eurozone. Another contribution stems from the applied econometric methodology, which differs from other nonlinear models with regard to the type of the threshold variable. While in STAR models, the transition variable denotes the lagged inflation differential; in our study, it represents the dynamic behavior of the inflation differential, which is the change in the inflation differential during a specific period. 


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