Monetary and Exchange Rate Policies of the Euro Area: Selected Issues

This Selected Issues paper estimates the potential output and the associated nonaccelerating inflation rate of unemployment in the euro area. The study presents a conceptual framework for analyzing currency movements, and highlights the transmission of import price shocks on consumer prices. The paper compares different measures of trend money growth, and analyzes the monetary conditions. The study describes the stability and growth pact, outlines a simple framework for studying fiscal policy behavior, and estimates European Union countries' past cyclical fiscal policy responses to output growth fluctuations.


This Selected Issues paper estimates the potential output and the associated nonaccelerating inflation rate of unemployment in the euro area. The study presents a conceptual framework for analyzing currency movements, and highlights the transmission of import price shocks on consumer prices. The paper compares different measures of trend money growth, and analyzes the monetary conditions. The study describes the stability and growth pact, outlines a simple framework for studying fiscal policy behavior, and estimates European Union countries' past cyclical fiscal policy responses to output growth fluctuations.

III. Tracking the Pass-Through of External Shocks to Euro-Area Inflation1

A. Introduction and Summary

1. Since the launch of monetary union, the euro area economy has been confronted by the largest import price shock in two decades. Rising oil prices and a weakening exchange rate quickly showed up in mounting headline inflation, and the subsequent pass-through to other retail prices have impacted—and complicated the reading of—conventional core inflation indicators. HICP inflation excluding energy and unprocessed food broke through the ECB’s 2 percent upper limit for price stability in April 2001 and has remained above it since.

2. Lagged pass-through remains an important factor shaping the area’s inflation outlook. The analysis in this paper finds that:

  • the regime change associated with the euro initially appeared to have slowed the degree of exchange rate pass-through to import prices and consumer prices; however, import prices have been catching up with normal pass-through patterns as euro weakness has lingered on;

  • the doubling in core HICP inflation since 1999 is essentially due to the pass-through of external shocks (and recent food price hikes);

  • underlying domestic inflation pressure has remained subdued;

  • as pass-through effects are worked off and domestic price pressure remains benign, annual core inflation is likely to drop below 2 percent in the not-too-distant future.

B. The Stages of Pass-Through

3. The pass-through of external price shocks to consumer prices occurs in two stages: the pass-through from exchange rate or oil price changes to import prices (Stage One); and the pass-through from import prices to retail prices (Stage Two). As for the latter, it is conventional to distinguish between direct effects—namely, changes in the retail price of imported consumer products (including energy consumed by households)—and indirect effects, which arise as changes in the cost of imported intermediate goods are passed along the production chain. Indirect effects may also arise through a “competing goods effect” whereby domestic firms utilize any competitive headroom offered by higher import prices to raise their own prices.

4. More broadly, exchange rate and oil shocks are likely to affect the level of output and demand, and they may have second-round effects on wages and domestic inflation pressure. The focus in this paper is on the transmission of import price shocks directly or indirectly on to consumer prices for given wages and unemployment.2

C. A Quick Primer on Pricing-to-Market Behavior

5. An important aspect of import price determination is the degree of “pricing-to-market”; i.e., the degree to which foreign producers align their prices to those of domestic suppliers in order to maintain market share.3 Empirically, pricing to market appears to be widespread for differentiated goods. Firms try to maintain market shares because these matter for future sales and profits when consumers face switching costs (e.g., related to information acquisition, network externalities, and long-term supply relationships). Hence, prices will tend to be set on the basis of longer-run average costs rather than short run fluctuations. In this setting, pricing-to-market may depend on how long the exchange rate change has lasted and how long it is expected to last.

6. Although pricing to market is mainly a short- and medium-term phenomenon, theory does not rule out that it may occur even in the long run. In a standard long-run or static model of pricing-to-market, oligopolistic suppliers set destination-specific price mark-ups (over production costs) as a function of the demand elasticity in each market: the higher the local elasticity of demand, the lower the mark up. In this situation, the degree of pricing-to-market depends on the perceived shape of the demand function. Demand curves less convex than a constant elasticity schedule imply less than complete pass-through-for—instance, a linear demand curve implies a pass-through coefficient of less than one half (Krugman, 1987).

7. A twist on the pricing-to-market story is that low inflation regimes may in themselves reduce pass-through coefficients (Taylor, 2000). In a world with price rigidity, the amount by which a firm matches an increase in costs (or in competitors’ prices) with an increase in its own price greatly depends on expectations about future cost and price movements. An economy with an inflation rate as low as its trading partners is less likely to experience permanent nominal depreciation because it could bring the real exchange rate out of line with fundamentals. Hence, low inflation economies should have less pass-through than economies with high and persistent inflation. Pass-through of oil price shocks would similarly depend on their expected persistence.

8. Taylor’s argument raises the possibility that the euro may engender a regime change in participating countries—particularly those that had above-average inflation and relatively less stable currencies prior to embarking on the convergence road to EMU. So does the view that the euro will lead to more local-currency pricing by foreign firms selling in the area (Devereux, Engel, and Tille (1999)).4

9. Pricing-to-market may occur both at the level of import prices (as foreign producers vary their margins) and retail prices (as importers and retailers do the same). Since data on import prices or unit values are readily available, the first stage is by far the easiest to analyze, and it has been the main focus of the literature on exchange rate pass-through. There is less empirical evidence on Stage Two.5 Nonetheless, the growing list of countries that have experienced large currency depreciations with little subsequent inflation pressure in the last decade has shown that—even when pass-through in Stage One has been nearly complete—pass-through to consumer prices in Stage Two can be limited. It also appears to have been smaller than in the (high-inflation) past.

D. Stage One: The Import Price Shock

Magnitude and anatomy of the external shock

10. The rise in world market oil prices and the slide in the euro against most major currencies have driven up the area’s import prices by almost 15 percent since the last quarter of 1997, when a barrel of oil cost $19 and the synthetic euro stood at $1.12 (Figure 1).6

Figure 1.
Figure 1.

Euro Area. External Price Shocks, 1995-2001

(Indices: 1997 Q4=I00)

Citation: IMF Staff Country Reports 2001, 201; 10.5089/9781451812992.002.A003

Sources: Eurostat, and ECB.1/ Import-weighted nominal effective exchange rate (with weights based on manufactures imports, 1995-99).2/ Staff estimate

11. Energy prices account for almost one half of the shock to import prices (Table 1). Within that, movements in the oil price in dollar account for two thirds of the total movement in the oil price measured in euro. Consequently, the external shock may be said to be roughly two-thirds exchange rate-related, and one third oil price-related.

Table 1.

Euro Area: Import Price Shock

(1997 Q4 to 2001 Q1)

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Sources: Eurostat, ECB. and staff calculations.

Contribution to import price change using 1997-2000 import weights.

Assuming that all of the change in energy import prices is attributable to changes in the oil price in USD and the EUR/USD rate.

Pass-through to date

12. An important question at the current juncture is whether import prices have adjusted fully to the underlying shocks. Changes in world market prices for oil and the US dollar have continued to be reflected in the prices of the area’s energy imports almost immediately. In the absence of new shocks. no further pressure is likely from this source.

13. As for non-energy prices, a back-of- the-envelope calculation reveals that more than half of the exchange rate change since end-1997 has been passed through to import prices (Table 2).

Table 2.

Euro Area. Exchange Rate Pass-Through for Non-Energy Import Prices

(from 1997 Q4 to 2001 Q1; in percent)

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Sources: Eurostat; OECD: IMF; staff calculations.

Import-weighted average of trading partners’ prices.

Defined as (a) - (b).

Defined as (c) / (d).

14. A different perspective on the same issue can be gained by investigating the degree of pricing-to-market. Under this hypothesis, the import price may be thought of as a weighted average of the domestic prices of euro-area suppliers and foreign costs:

pm = α ppid – (1-α) ppif

where pm is import prices, ppid is domestic producer prices, ppif is foreign producer prices measured in euro, all excluding energy and measured in logs, and a is the pricing-to-market coefficient.

15. This framework can be used to provide a snap-shot of pricing-to-market to date: the 8.4 percent rise in non-energy import prices since 1997 Q4 (cf. Table 3) is a linear combination of the increase in domestic prices (3 percent) and rising foreign costs in euro (14 percent) with a weight of roughly one half given to each factor.

Table 3.

Euro Area. Pricing-to-Market

(from 1.997 Q4 to 2001 Q1; in percent)

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Sources: Eurostat; OECD: IMF; staff calculations.

Consumer and capital goods.

Weight on domestic prices (b) relative to foreign prices (c) in determining import prices (a).

16. If domestic producer prices rise in response to the demand and cost pressures of an exchange rate depreciation, pass-through can be high even when there is pricing-to-market. If purchasing power parity holds in the long run, exchange rate pass-through will ultimately be complete.

Has the euro spurred a regime change?

17. To assess whether the developments outlined above are in line with historical experience, import price equations were estimated for the five largest euro-area countries on national price data spanning 1975-98, with the period 1999-2000 reserved for testing possible structural breaks after the introduction of the euro. The estimated models essentially relate non-energy import prices to domestic producer prices (the pricing-to-market element) and foreign costs (the pass-through element).7

18. The results indicate that the historical degree of pricing to market was highest in Germany, followed by a middle group of France and the Netherlands, while it was smallest in Italy and Spain (Table 4). These results are consistent with the existing evidence in the pricing-to-market literature in suggesting that:

  • pricing-to-market is a common phenomenon across countries;

  • pricing-to-market is most pronounced in large countries with low inflation regimes, whereas exchange rate pass-through has been stronger for countries with historically high inflation.

Table 4.

Import Prices. Long-Run Coefficients

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Source: staff estimates.

19. However, despite signs of slower pass-through to import prices in the post-1999 sample in some cases, the estimations failed to uncover clear signs of regime change where one would most expect it, namely in those countries that formerly had comparatively high inflation (Italy and Spain).

20. A cross-country examination reveals that non-energy import prices have risen roughly in lock-step in Germany and the Netherlands since the launch of EMU, somewhat more in Italy and Spain, and clearly less in France (Figure 2). These differences are not related in any- straightforward manner to the trading patterns of the individual countries-Germany and the Netherlands have seen the largest effective depreciation on account of larger extra-area trade.

Figure 2.
Figure 2.

Euro Area: Cross-Country Perspective. 1995-2001

(Indices: 1998=100)

Citation: IMF Staff Country Reports 2001, 201; 10.5089/9781451812992.002.A003

Sources: National sources; Eurostat; OECD; International Financial Statistics, IMF; and staff calculations.1/ Price indices for Germany and France; unit values for Italy and Spain; spliced series for the Netherlands.

21. In 1999, euro-area import prices initially increased less than might have been expected relative to the extent of currency depreciation (Figure 3)-possibly because economic operators did not expect euro weakness to last. But as the euro failed to recover decisively against other currencies, import prices have caught up. Pass-through is no longer out of line with historical experience, and (with the possible exception of France), the underlying shocks appear to have been incorporated in import prices.

Figure 3.
Figure 3.

Euro Area: Pricing-to-Market for Non-Energy Imports, 1995-2001

(Indices: 1998 = 100)

Citation: IMF Staff Country Reports 2001, 201; 10.5089/9781451812992.002.A003

Sources: national sources; Eurostat; OECD; IFS, IMF; and staff calculations.1/ Producer prices for capital and consumer goods.

E. Stage Two: The Impact on Consumer Prices

22. In what follows, the impact on retail prices is gleaned from a combination of methods, including input-output calculations, econometric specifications, and analysis of alternative measures of domestic inflationary pressures.

Import and energy content in consumers’ expenditure

23. The direct share of imported consumer items in euro-area private consumption (excluding imputed rents) is modest (around 7 percent).8 Yet, the total import dependency is larger when intermediate inputs used in the domestic production of consumer items are considered. Based on total import content (around 15 percent), a shock to import prices of the magnitude experienced since 1997 would translate into an increase in the HICP price level by 2½ to 3 percentage points if there were full pass-through to retail prices.9

24. Almost half of the import price shock is attributable to higher oil prices in euro. Most of the direct effect of this shock has already come through to consumer energy prices: exacerbated by indirect tax increases, energy price hikes have added 1½ percent to the HICP level since the fourth quarter of 1997.10

25. HICP inflation excluding energy and unprocessed food (HICPX) has doubled over the last couple of years and it breached 2 percent in April 2001. Prices accelerated for all three components of HICPX, namely processed food (including alcohol and tobacco), industrial goods, and services (Figure 4). While the increase in processed food prices was distorted by supply shocks in the food sector, the pass-through of external shocks is clearly identifiable in the prices of industrial goods and services. Inflation for industrial goods has increased from ½ percent one year ago to 1½ percent, while services prices have accelerated from below 2 percent to 2½ percent.

Figure 4.
Figure 4.

Euro Area: Components of HICPX Inflation

Citation: IMF Staff Country Reports 2001, 201; 10.5089/9781451812992.002.A003

26. In general, the services sector is more shielded from import price shocks than the industrial sector. Examination of the area’s production structure with the help of provisional input-output data indicates that the 6 percent direct and indirect import content in services compares to some 22-23 percent for food and non-energy industrial goods (Table 5). At first blush, one might therefore be tempted to conclude that the rise in services inflation during 2000 and 2001 was unrelated to the external shocks. Yet, the energy used in the production of services—e.g., for heating, transport, and distribution—is not much smaller than that of the industrial sector (Table 6). This gives reason to believe that energy price shocks have had a significant impact on price movements in services as well (more below on the dynamics of the transmission of energy price shocks to final sales prices).

Table 5.

EU5. Import Content in Consumption

(based on input-output analysis; in percent 1/)

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Source: Eurostat, and staff calculations.EU5 = Germany, France. Italy. Spain, and the Netherlands.

Harmonized input-ouput data projected to 2000; provisional.

Excluding Imputed Rents.

Table 6.

EU5. Energy Content in Consumption

(based on Input-Output analysis; in percent 1/)

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Source: Eurostat, and staff calculations.EU5 = Germany, France. Italy. Spain, and the Netherlands.

Harmonized input-ouput data projected to 2000; provisional.

Excluding Imputed Rents.

Dynamics and tests for regime change

27. In order to gain insight into the speed with which exchange rate changes have affected consumer prices in the past, consumer prices have been modeled as a mark up over costs:11

p = log(μ) + α ulc + δ pxf + γ poil.

where p denotes the CPI level; μ the mark-up factor; ulc nominal unit labor costs in the total economy; pxf foreign non-oil export prices in synthetic euro; and poil the oil price in euro (lower-case letters denote logs of the variables). Both the mark-up and costs may vary over the cycle. It turns out that the mark-up has been steadily increasing over the estimation period (mirroring the trend decline in the labor share in value-added). A time trend is added to capture this feature which reflects, among other things, a rising capital-output ratio and higher indirect taxes.

28. Using an estimation procedure suggested by Pesaran and Smith (1998), the estimated long-run equation over the sample period 1976-1998 is:


The long-run coefficient on pxf is virtually identical to the import share indicated by input-output analysis. The long-run coefficient on poil ties in well with a widely used rule of thumb for the direct impact of oil prices on HICP (namely, that a 10 percent shock to oil prices raises HICP by 0.1 percent), when indirect effects are borne in mind.

29. Starting from a general dynamic model and simplifying to a statistically acceptable error correction model yields the following equation for the one-quarter change in prices:


The impulse responses to exchange rate and oil price shocks are shown in Figure 5. Historically, 80 percent of an exchange rate shock fed through to consumer prices within two years. For oil, the direct effect came through to CPI within one quarter, while the full impact tended to have been reached four to five quarters after the shock.

Figure 5.
Figure 5.

Euro Area: Pre-Euro Impulse Responses of CPI to External Shocks

Citation: IMF Staff Country Reports 2001, 201; 10.5089/9781451812992.002.A003

Sources: Eurostat; and staff calculations.

30. One would expect pass-through to be slower in a low inflation regime where exchange rate changes have less persistence. The out-of-sample performance of the equation does indeed suggest that pass-through has been (modestly) reduced after the introduction of the euro. In the early part of the post-sample EMU period, actual inflation was below the model prediction—although all observations remain within their 95 percent confidence bands. Yet, the rise in consumer prices in late 2000 and early 2001 (exacerbated by food price shocks) brought actual CPI closer to projected CPI by the first quarter of 2001.

Domestic inflation pressure remains subdued

31. The impulse responses above may be used to extract the transmission of energy price shocks from core HICP.12 The resulting indicator-which removes both the direct and indirect effects of energy price shocks, as well as food price shocks-is denoted by HICPXX and shown in Figure 6. After hovering in the 1-1¼ percent range in 1999-2000, HICPXX inflation has risen to 1½ percent during 2001, suggesting that producers and retailers may have begun to pass on earlier exchange rate increases on to consumers.

Figure 6.
Figure 6.

Inflation Net of Supply-side Effects

Citation: IMF Staff Country Reports 2001, 201; 10.5089/9781451812992.002.A003

32. More conventional indicators of domestically generated inflation pressure such as the GDP-deflator and normalized unit labor costs have remained similarly well behaved, rising at an annual rate of 1-1¾ percent (Figure 7). The GDP-deflator is a proximate measure of domestically generated inflation: in addition to consumer items it includes the prices of domestically produced investment goods, exports, and government consumption, but excludes the prices of imports.

Figure 7.
Figure 7.

HICP and Domestic Inflation Pressures

Citation: IMF Staff Country Reports 2001, 201; 10.5089/9781451812992.002.A003

Sources: Eurostat, ECB, national sources, and staff calculations.1/ Using five-year moving average of productivity and three-quarter moving average of compensation per head.

33. If domestic producers were to react to an import price shock by immediately passing on higher costs to final sales prices, the GDP-deflator would be unaffected, all else equal. If such pass-through is gradual, however, higher import prices will temporarily lower the GDP-deflator. reflecting compressed profit margins. The slowing of the GDP deflator to an annual rate of 1 percent (year on year) in the second half of 1999 likely reflects this phenomenon. The subsequent acceleration to 1½ percent in the second half of 2000 and 1.9 percent in the first quarter of 2001 (distorted by food price shocks) is consistent with the view that companies have subsequently been passing on these costs to their sales prices.

34. The cumulative pass-through to non-energy consumer prices may be gleaned by comparing the actual evolution of HICPX with a counterfactual scenario.13 In this metric, the cumulated impact of import price shocks on HICPX prices by August 2001 is ¾ to 1 percentage point, implying that slightly more than one half of the potential long-term effect on non-energy prices has come through.

F. Near-Term Prospects

35. Given that the price shock has not fully fed through to consumer prices, HICPX inflation is likely to remain above domestically generated inflation at least for the remainder of this year (predicated on the current constellation of exchange rates and oil prices). This does not exclude a deceleration in HICPX since the existing gap between HICPX and homegrown inflation allows for continued gradual adjustment of the price level to the import shock.

36. Producer prices of consumer goods are an important leading indicator for the rate of consumer price inflation for industrial goods (Figure 8). The peak in producer price inflation (for consumer goods) in April of this year has been followed by peak in HICP inflation for industrial goods. In a situation where demand prospects have worsened significantly, oil prices and the euro have stabilized or improved, and the lagged impact of food price shocks is gradually subsiding, producer price inflation is likely to decline significantly in the time ahead. This decline is expected to show up in easing price pressure for industrial goods, and HICPX is likely to drop below 2 percent in the not-too-distant future-possibly by the turn of the year 2001/2002.

Figure 8.
Figure 8.

Non-Energy Consumer Goods: PPI and CPI

Citation: IMF Staff Country Reports 2001, 201; 10.5089/9781451812992.002.A003

Source: Eurostat.


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Prepared by Mads Kieler (


Wage developments and the macroeconomic outlook for the euro area are considered in the staff report on the 2001 Article IV consultation (SM/01/289).


Several papers formalize such ideas, including Krugman (1987), and Froot and Klemperer (1988). See Goldberg and Knetter (1997) for an overview of the literature.


Although Obstfeld and Rogoff (1999) note that the time horizon over which trade invoicing induces price stickiness appears too brief to have a large impact on macroeconomic interactions at business cycle frequencies.


Import prices have risen by 25 percent since early 1999 when oil prices were exceptionally low. A proxy for extra-area import prices for goods and services has been derived from national accounts statistics by assuming that intra-area trade prices evolve in line with the area’s domestic producer prices of finished goods. This proxy is broadly consistent Eurostat’s unit value series (which covers goods only).


Details on the estimation procedure are available upon request.


The retail prices of imported consumer products generally contain a significant component of domestic value-added in the distribution and retail sectors as well as taxes. The input-output share refers to the pure import content.


Including the associated increase in ad valorem indirect taxes.


In addition, shocks to fresh food prices-related to unusual weather conditions and animal diseases that reduced food supply and engendered a switch to niche products-helped to drive up headline inflation to a peak of 3.4 percent (year-on-year) in May 2001.


The model and estimation strategy largely follow de Brouwer and Ericsson (1998).


It is assumed that any regime change on account of the euro concerns the pass-through of exchange rate changes rather than energy prices.


In the “no shocks” scenario, core inflation is postulated to average 1.3 percent since March 1998, consistent with indicators of domestically generated inflation pressure.

Monetary and Exchange Rate Policies of the Euro Area: Selected Issues
Author: International Monetary Fund