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See de Haan (2010) for a review of the literature. Another possible explanation of inflation differentials would be the Balassa-Samuelson effect. However, little evidence of this effect can be found (see Rabanal, 2009 for Spain; Beck et al., 2009 and ECB, 2005 for broader samples of euro area countries).
The model has two regions that form a currency union and that are characterized by a variety of frictions: matching frictions and wage rigidity in the labor market, monopolistic competition in product markets and adjustment costs on pricing.
Andres, Ortega and Vallés (2008) argue that inflation differentials in a monetary union are often assumed to originate primarily from the lack of competition in the non-traded sector but there is evidence showing substantial differences among traded goods inflation rates. In their model, each country produces differentiated goods traded in monopolistic competitive markets. Price discrimination across countries is possible due to differences in the degree of market competition.
Cyprus, Malta, Slovakia and Slovenia are excluded from the comparison since they joined the euro area much later (in or after the mid-2000s).
Services in the consumption basket include items such as communication, housing, recreation and personal care, and transport.
ECB (2005) also finds that services prices and differences in wage developments have been major sources of inflation persistence.
A more refined way to measure external shocks (currently captured by time dummies and changes in the nominal effective exchange rate) would be to control for imported good prices, distinguishing between oil and non-oil, and to interact these respectively with the share of oil-refined products in the consumption basket and with the degree of openness of the country. An element missing in the analysis is the role of indirect taxation and government-set prices in explaining inflation developments.
In addition to the institutions presented in the paper, we also looked at the impact of minimum wages (which were never significant) and unemployment benefit replacement rates (which had the wrong sign but were not robust).
The sample countries are Austria, Belgium, Finland, France, Germany, Ireland, Italy, Netherlands, Portugal, and Spain. Greece and Luxembourg could not be included because the collective bargaining indicator is not available for them.
Using the more comprehensive OECD product market variable (only available for a shorter time period) and disaggregating it into its different sub-indicators (state control, barrier to entrepreneurship, regulatory and administrative opacity, administrative burden on start-ups, and barriers to competition) did not show a significant impact either.
Although the formal indicator is not available for Greece, its bargaining system can best be described as having an intermediate level of coordination.
The contribution of each regressor to the inflation differential can be calculated as the product of the regressor’s coefficient and the difference between the values of the regressor for the country and the euro area average. For interaction terms, e.g. X*π, the contribution of X is calculated as
These are likely underestimates though since they are a simple average of first-year effects on inflation, and do not take into account the dynamic effects of lower inflation on subsequent years. A similar decomposition of the inflation differential using the non-linear model shows similar contributions, with a somewhat larger role of labor market institutions.
Indeed, Ireland’s labor market institutions are more efficient than the euro area average, and the inflation differential is mostly captured by a country fixed effect. There is some evidence that among other factors, differences in relative productivity levels may have contributed to the inflation differentials (positively for Ireland and negatively for Portugal and Spain) by affecting the long-run price level toward which the countries are converging.
This simulation is based on the linear model and takes into account the impact on inflation in subsequent years through lower lagged inflation but not through lower output gap (since we do not have a model of the output gap).