Felix Geiger and Heinz-Peter Spahn

One size fits none? Common monetary policy and inflation differentials in EMU

20 Seiten · 3,83 EUR
(11. Januar 2008)

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Introduction:

Nominal divergence is the deviation of absolute, i.e. money prices, from average values, which emerge on homogenous markets. On the one hand, such deviations may be interpreted as violations of the ‘law of one price’, signalling market failure or imperfections. Either agents are to blame for a lack of rationality, or arbitrage is limited because of institutional restrictions. On the other hand, it has to be examined whether the market is homogenous in the first place. If not, persistent price differences reveal a market separation, and nominal divergence turns out to be a relative price.

Nominal divergence may appear on labour, goods and asset markets, i.e. on markets where flows or stocks are traded. Financial integration in EMU has made great strides; we observe interest rate conformity even of those assets that cannot safely be regarded as homogenous assets, namely public debt paper issued by different national agencies. Real estate prices, however, show large divergence across Europe. There are several possible explanations:

-� In a process of general asset price inflation (which is currently observed as a mirror image of euro M3 growth) agents are searching for real estate objects in order to improve their portfolio allocation. Because of lagging price developments and expected locational quasirents in some countries, market equilibrium is not yet achieved.

- Structural change, which is a by-product of the catching-up process, brings about strong demand for real estate objects in some countries. - Demand for real estate may show particular dynamics because national inflationary expectations drift apart from average EMU inflation target. The reason for such discrepancies has to be found by analysing goods and labour market dynamics.

EMS already was oriented towards the elimination of nominal wage differentials throughout Europe. Wage inflation, which due to a lack of credibility of national monetary institutions diverged from the Bundesbank norm, was expected to be lowered to the German standard by means of fixed exchange rates. EMU has sharpened this approach by abolishing exchange rates altogether. From the viewpoint of the institutional theory of credibility and inflation it could be argued that a common EMU rate of inflation would emerge, as the possibility of devaluation no longer existed and the common goods market improved. Actually, national inflation rates have adjusted to a large extent; what remains is a small amount of inflation divergence, which – looking at the national level – shows strong persistence (Figure 1). Small and persistent differences with respect to inflation rates run up to large differences of national price levels. Hence, it is important to understand the origins and consequences of such adjustment failures.