Research Discussion Papers, Bank of Finland
No 15/1998:
Is There Scope for Inflation Differentials in EMU? An Empirical Evaluation of the Balassa-Samuelson Model in EMU Countries
Enrique Alberola and Timo Tyrväinen
Abstract: The Balassa-Samuelson (BS) model is evaluated in eight of
the eleven EMU countries. This model suggests that productivity
differentials between traded and non-traded goods sectors generate sectoral
inflation differentials (dual inflation). Furthermore, differentials in the
degree of dual inflation induce inflation differentials between countries.
The standard BS model implies a cointegration relationship between relative
prices and sectoral productivities. While this link generally seems to
exist, the magnitudes of the parameter estimates are not in accordance with
the theoretical model in most countries. As the presumed uniformity of
sectoral wages is rejected in most cases, relative wages were allowed to
enter the estimation. This extended BS model is endorsed by the data in
every country. Simulations based on these results were carried out to
quantify possible inflation differentials. Setting EMU-wide inflation equal
to 2 per cent and assuming that PPP holds for traded goods, the projected
inflation varies around the EMU-average within a margin of some +/-1
percentage points across the countries.
Keywords: sectoral productivity; inflation differentials; EMU; (follow links to similar papers)
JEL-Codes: E31; F15; (follow links to similar papers)
46 pages, July 20, 1998
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