Inflation dynamics and the role of domestic factors

The observed inflation differentials across euro area countries, along with the divergence between the Harmonised Index of Consumer Prices (HICP) and GDP deflator trends within countries, highlight the potential role of country-specific institutional and structural characteristics in shaping inflation dynamics in response to import price shocks. This paper investigates the role of domestic factors in shaping inflationary dynamics. It employs a Dynamic Stochastic General Equilibrium (DSGE) model to examine the macroeconomic effects of a temporary import price shock under varying degrees of real wage rigidity in the labour market. The results indicate that economies with high degrees of real wage rigidity are likely to experience higher and more persistent inflationary pressures than economies with low degrees of real wage rigidity. Real wage rigidities constrain firms from absorbing part of the higher import costs through reductions in labour costs, thus resulting in greater pass-through of input costs to final prices, which in turn generates strong and persistent inflation and adversely affects employment and output. In contrast, in economies with low real wage rigidities firms have more flexibility in managing rising import costs, thereby mitigating the negative impact on output. Additionally, the paper demonstrates a relatively straightforward methodology using national accounts data to explore the relationship between domestic factors and inflation dynamics. Case studies for the euro area and Greece reveal that the rise in domestic inflation since 2021 is largely associated with an increase in profits. Labour costs are also linked to inflationary pressures, though their contribution is relatively smaller than that of profits. In Greece, the increase in profits is primarily associated with the services sector, followed by the industry sector.