Inflation Differentials in the EMU

Abstract

The Maastricht Treaty in 1991 was a major step for the European countries to become more closely integrated and cooperated by introducing the foundations of the European Economic and Monetary Union (EMU). The EMU is an economic integration among the European Union (EU) member states for the purpose of promoting price stability, sustainable economic growth, and maintaining below but close to 2 percent inflation rate in the medium run. Contrary to public expectations on its promising prospects, however, the EMU had confronted two severe financial crises: The Global Financial Crisis in 2008 and the European Sovereign Debt Crisis in 2010. These financial crises in the euro area were primarily driven by economic imbalances, particularly in terms of inflation rates, between the member states. Therefore, large inflation differentials between the member states without the ECBs serious effort to address them had triggered severe financial risk and instability in the euro area during the past decade. However, there has been a trend reversal in fluctuation of the inflation differentials since 2012; the inflation differentials have now become close to historic lows due to the global phenomenon of inflation synchronization. Despite extremely small inflation differentials in the EMU at present, however, concerns over the likelihood of another debt crisis in the euro area have recently been raised again. In fact, in contrast to the past decade, larger inflation differentials are more desirable in the present times in order to avoid another debt crisis. This paper explores the key determinants of the inflation differentials in the euro area during the past (1996 – 2012) and the present times (2013 – 2018). Our results suggest that imbalances in unemployment rate, labor market rigidity, product market rigidity, oil dependency, and government balance between the member states had been the key factors in affecting the inflation differentials during 1996 – 2012. However, the effects of these factors have significantly reduced since 2013 and only unemployment rate and oil dependency have continued to remain statistically significant. Based on our estimation results, we further examine which policy measures are needed at individual country level in order to prevent another debt crisis.