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Inflation and Business Cycle Convergence in the Euro Area: Empirical Analysis Using an Unobserved Component Model

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  • Stephen Hall
  • Sérgio Lagoa

Abstract

The literature on optimum currency areas states that large inflation differentials can undermine monetary union. In the euro area, inflation rates diverged after the creation of the single currency, but started to converge again from mid-2002. Against this background, we assess the convergence of inflation rates and business cycles and study the relationship between them. The analysis is made using an unobserved component model estimated with the Kalman filter. In general, from 1980 to 2008 inflation rates and business cycles became more aligned in the euro area, but inflation rates converged more quickly than business cycles. The output gap is found to be a better indicator of the business cycle than unit labour cost when studying convergence. By looking at the causality between the convergence of inflation and output gap, it is found that inflation divergence has a limited destabilising economic impact. Copyright Springer Science+Business Media New York 2014

Suggested Citation

  • Stephen Hall & Sérgio Lagoa, 2014. "Inflation and Business Cycle Convergence in the Euro Area: Empirical Analysis Using an Unobserved Component Model," Open Economies Review, Springer, vol. 25(5), pages 885-908, November.
    • Handle: RePEc:kap:openec:v:25:y:2014:i:5:p:885-908
    DOI: 10.1007/s11079-014-9313-0
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    Cited by:

    1. Ayako Saiki, 2015. "The Endogeneity of Exchange Rate Pass-Through: Some European Evidence," Open Economies Review, Springer, vol. 26(5), pages 893-909, November.
    2. Dridi, Jemma & Nguyen, Anh D. M., 2017. "Inflation Convergence In East African Countries," MPRA Paper 80393, University Library of Munich, Germany.
    3. Nestor Azcona, 2022. "Business Cycle Co-Movement in Europe: Trade, Industry Composition and the Single Currency," Open Economies Review, Springer, vol. 33(1), pages 121-139, February.

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    More about this item

    Keywords

    Inflation convergence; Business cycle convergence; Kalman filter; Economic Integration; E31; C32;
    All these keywords.

    JEL classification:

    • E31 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Price Level; Inflation; Deflation
    • C32 - Mathematical and Quantitative Methods - - Multiple or Simultaneous Equation Models; Multiple Variables - - - Time-Series Models; Dynamic Quantile Regressions; Dynamic Treatment Effect Models; Diffusion Processes; State Space Models

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