Inflation differentials in the euro area: the case of the Spanish economy

The existence of divergences between the inflation rates of the countries or regions belonging to a monetary union is a phenomenon common to all such unions and does not by itself hamper their proper functioning. In fact, the dispersion of national inflation rates within the euro area is comparable to that seen across regions in the United States. Uneven growth of national price indices may, in principle, be a direct result of specific developments, such as changes in regulated prices and in indirect taxes, of differences in the cyclical positions of the economies in question or of their varying degree of exposure to particular shocks, such as those affecting the oil market [see, for example, ECB (2003)]. However, a singular feature of the inflation differentials within the euro area is their high degree of persistence. That is to say, some countries, like Germany and France, have had inflation rates systematically below the average, while others, like Portugal, Spain, Ireland and Greece have regularly had positive inflation differentials with respect to the euro area as a whole. This observation has given rise to the recent appearance of theoretical, empirical and economic analyses seeking to study the determinants and normative implications of the persistence of inflation differentials across the euro area member countries. It has sometimes been argued that the persistence of inflation differentials may be associated with real convergence or catching-up. Countries in this situation tend to record higher relative productivity growth in the sector exposed to international competition, which may lead to a larger increase in wages and prices than in the mature economies of the monetary union. This is known as the Balassa-Samuelson hypothesis, according to which inflation differentials result from efficient adjustment by the various economies to productivity developments and do not, therefore, entail any change in their competitiveness or any direct adverse effects on the efficacy of the single monetary policy. However, although productivity developments may explain the medium and longterm dynamics of relative prices [see Ortega (2003)], the Balassa-Samuelson hypothesis cannot be reconciled with the sectoral price and productivity developments in Spain [see Estrada and López-Salido (2002 and 2005] and other euro area countries [see ECB (2003)] since 1999, so that it cannot provide a general explanation of the inflation differentials observed in the euro area. An alternative hypothesis, enjoying greater empirical support, associates the persistent inflation differentials across the various national economies belonging to the euro area with the rigidities characterising the price and wage adjustments in each of them. These give rise to uneven developments in the national price indices in the face of common or specific shocks. According to this reasoning, inflation differentials are not a benign development, but a reflection of imperfections in factor, goods and services markets that affect the economies’ competitiveness and may make implementation of the single monetary policy more complex [see, for example, Benigno and López-Salido (2003)]. This second line of analysis has important normative implications that can, however, only be specified to the extent that the type of shock and the nature of the frictions (or rigidities) which contribute to generating the inflation differentials are identified. In particular, it would be appropriate to analyse whether the discrepancy in price growth is a consequence of common shocks transmitted in a different way in each economy or, rather, a consequence of idiosyncratic shocks in each economy. Also, the relative importance of supply and demand shocks needs to be estimated and, in particular, evidence needs to be obtained on those aspects of price and wage formation that have the strongest influence on inflation differentials. Recent literature provides abundant evidence on these issues, usually making use of general equilibrium models with nominal rigidities in the neo-Keynesian tradition. However, these studies do not provide evidence which might enable the determinants of the inflation differentials observed in the euro area to be characterised generally. On the contrary, the heterogeneity of the findings would seem to suggest that the observed discrepancies in price growth across countries do not always stem from the same causes. Thus, a proper understanding of the phenomenon requires each economy to be examined in greater depth. It is precisely this strategy that has been followed in the research on which this article is based, with the aim of identifying the specific causes of the Spanish economy’s persistent inflation differential with respect to the euro area average, the effects of such differentials on economic activity and certain implications for the conduct of economic policy. The rest of this article is structured as follows: Section 2 describes those characteristic features of Spanish macroeconomic developments in recent years that may be relevant to explaining the path of the inflation differential. Section 3 explores the factors determining the path of consumer prices in Spain on the basis of a general equilibrium model. Section 4 describes the macroeconomic adjustment in response to the shocks that generate the observed inflation differentials. Finally, Section 5 provides certain normative conclusions.