Inflation Differentials and the Differences of Monetary Policy Effects among Euro Area Countries Eiji Ogawa (Hitotsubashi University and EUIJ Tokyo) Masao Kumamoto (Tokyo Keizai University) 11/27-28/2008 EMU: 10 years of Success?

Motivations A unified monetary policy has been adopted among the euro area countries since the third stage of Economic and Monetary Union (EMU) started on 1 January 1999. Persistent inflation rate differentials among euro area countries cause the persistent short-term real interest rate differentials in the situation where all countries face the same short-term nominal interest rate set by the Eurosystem under the money market integration. A unified monetary policy may be excessively tight for lower inflation countries and loose for higher inflation countries therefore. It may have different effects on euro area countries. 11/27-28/2008 EMU: 10 years of Success?

Motivations Inflation Persistence includes the following factors: Intrinsic persistence: dependence of inflation on its own past Expectation-based persistence: the persistence due to the formation of inflation expectation Extrinsic persistence: persistent changes in the determinants of inflation (marginal costs or output gaps) =>The differences in degree of inflation persistence among countries might be contributed to sources of the persistent inflation differentials. 11/27-28/2008 EMU: 10 years of Success?

Motivations Inflation Persistent Network (Altissimo, et al. (2006)) There is heterogeneity in the degree of price stickiness among sectors. The frequency of price changes is relatively infrequent particularly for service sectors. =>It is important to distinguish the tradable goods sectors from non-tradable goods sectors. 11/27-28/2008 EMU: 10 years of Success?

Shares of Economic Activities across Sectors 11/27-28/2008 EMU: 10 years of Success?

Objectives This paper has objectives to investigate the following issues: whether there exist persistent inflation differentials among euro area countries, whether there exist differences in inflation persistence between tradable goods and non-tradable goods, which factors causes the inflation differentials among intrinsic, expectation-based, and extrinsic persistences, what is effect of monetary policy on inflation rate among euro area countries. 11/27-28/2008 EMU: 10 years of Success?

Related Literatures Inflation differentials and Inflation persistence Angeloni and Ehrmann (2004), von Hagen and Hofmann (2004) , Hofmann and Remsperger (2005), Altissimo, et al . (2006) Llandes (2007) Small open economy DSEG model Justiano and Preston (2004), Galí and Monacelli (2005), Santacreu, (2005) Bayesian Estimation with DSEG model Lubik and Schorfheide (2005) Schorfheide (2007), An and Schorfheide (2007) 11/27-28/2008 EMU: 10 years of Success?

Convergence of Inflation Rates We use two measurements of convergence to measure inflation rates convergences among the euro area countries. - convergence: inflation rate in countries with relatively higher inflation rates has a tendency to decrease more rapidly than that in countries with relatively lower inflation rates. - convergence: cross-country dispersion (standard deviation or variance) of inflation rates has a tendency to decrease over time. 11/27-28/2008 EMU: 10 years of Success?

- convergence Estimated equation: : inflation deviation from average, : total inflation rate, inflation rate of tradable goods, or inflation rate of non-tradable goods A negative => change of inflation rate is inversely related to the deviation of inflation rate from average Panel unit root methods (Levin-Lin-Chu (LLC) and Im, Pesaran and Shin (IPS) tests) is employed. 11/27-28/2008 EMU: 10 years of Success?

LLC and IPS tests LLC test tests for the null , against the alternative IPS test allows to differ across countries tests the null for all i, against the alternative for , but for . 11/27-28/2008 EMU: 10 years of Success?

- convergence Estimation equation: Variance of inflation rates is stationary.　=> cross-country dispersion has decreased Augmented Dickey-Fuller (ADF) unit root test method 11/27-28/2008 EMU: 10 years of Success?

Data Analytical period: 1999Q1 to 2007Q4 Sample countries: 12 euro area countries (Austria, Belgium, Finland, France, Germany, Italy, Ireland, Luxemburg, Netherlands, Spain, and Portugal ) Total inflation rate: calculated from HICP Inflation rate of tradable goods : calculated from PPI on industry (classified in C, D, E in ISIC Rev.3) Inflation rate of non-tradable goods: calculated from HICP on Services (overall index excluding goods) 11/27-28/2008 EMU: 10 years of Success?

Total Inflation Rates 11/27-28/2008 EMU: 10 years of Success?

Inflation Rates of Tradable Goods 11/27-28/2008 EMU: 10 years of Success?

Inflation Rates of Non-tradable Goods 11/27-28/2008 EMU: 10 years of Success?

Standard deviation of inflation rates 11/27-28/2008 EMU: 10 years of Success?

Empirical Results 11/27-28/2008 EMU: 10 years of Success?

Empirical Results of -convergence The null hypothesis of is rejected for inflation rates of tradable goods while it is not rejected for both total inflation rates and inflation rates of non-tradable goods in the case of LLC test . The null hypothesis is rejected for all of the inflation rates in the case of IPS test. =>Inflation rates of tradable goods among the euro area countries are in a process of convergence at the same speed while both total inflation rates and inflation rates of non-tradable goods are in a process of convergence at different speeds. 11/27-28/2008 EMU: 10 years of Success?

Empirical Results for -convergence The hypothesis of stationarity in variance of inflation rates is rejected for both total inflation rates and inflation rates of non-tradable goods while it is not rejected for inflation rates of tradable goods. =>Cross-country dispersion in inflation rate of tradable goods has reduced among the euro area countries while that in total inflation rates and inflation rates of non-tradable goods have not reduced. 11/27-28/2008 EMU: 10 years of Success?

Model: Settings Small open economy with complete international financial markets and perfect capital mobility Infinitely-lived households maximize their utility function which depends positively on consumption and negatively on labor supply. A continuum of monopolistically competitive tradable good firms and non-tradable goods firms produce a differentiated good. They can set a new price with probability in staggered contracts á la Calvo (1983). A fraction of the firms are “forward-looking” firms, while the remaining fraction　 are “backward-looking” firms. 11/27-28/2008 EMU: 10 years of Success?

Model: Recapitulation <IS Curve> <New Keynesian Phillips Curves> international adjustment mechanism intrinsic persistence expectation-based persistence extrinsic persistence 11/27-28/2008 EMU: 10 years of Success?

Model: Recapitulation <Uncovered Interest rate Parity> <Monetary Policy: Tailor’s Rule> <Foreign Economy> 11/27-28/2008 EMU: 10 years of Success?

Bayesian Estimation (1) Solving linear rational expectations model, (2) Adding measurement equation to obtain the state space form, (3) Evaluating the likelihood function using the Kalman filter to obtain the posterior density function, (4) Calculating the posterior mode using a numerical optimization routine, (5) Deriving the posterior distribution numerically using a Monte Carlo Markov chain (MCMC) algorithm (Metoropolis-Hastings algorithm) =>See Schorfheide (2000) for details 11/27-28/2008 EMU: 10 years of Success?

Data Nine shocks ⇒ Nine observable variables Analytical periods: 1999Q1 to 2007Q4 Sample countries: France, Germany, Italy, Netherlands and Spain domestic real GDP(y) : calculated from seasonally adjusted GDP volume index smoothed by Hodrick-Prescott filter inflation rates of tradable and non-tradable goods : the same in section 2. interest rate (r): three-month Euribor exchange rates ( ): nominal exchange rate of euro/US dollar 11/27-28/2008 EMU: 10 years of Success?

Data foreign real GDP (y*): calculated from seasonally adjusted GDP index in U.S. smoothed by Hodrick-Prescott filter inflation rates of foreign tradable goods : calculated from PPI on Industry classified in C,D and E by ISIC Rev.3) in U.S. inflation rates of foreign non-tradable goods : calculated from CPI on service in U.S. foreign interest rate (r*): money market rates with three-month maturities in U.S. 11/27-28/2008 EMU: 10 years of Success?

Priors 11/27-28/2008 EMU: 10 years of Success?

Empirical Results: France 11/27-28/2008 EMU: 10 years of Success?

Empirical Results: Germany 11/27-28/2008 EMU: 10 years of Success?

Empirical Results:Italy 11/27-28/2008 EMU: 10 years of Success?

Empirical Results: Netherlands 11/27-28/2008 EMU: 10 years of Success?

Empirical Results:Spain 11/27-28/2008 EMU: 10 years of Success?

Empirical Results IS curves The coefficients on real interest rates are estimated with relatively wide range from 1.59 (Spain) to 2.24 (France). ⇒Single monetary policy would have different effects on GDP. The coefficients on the change in real exchange rate are also estimated with wide range from 0.24 (Spain) to 0.48 (Netherlands). ⇒The degrees of international adjustment mechanism of inflation are different among countries. 11/27-28/2008 EMU: 10 years of Success?

Empirical Results New Keynesian Phillips Curves: intrinsic persistence The coefficients on backward-looking terms are larger in non-tradable sectors than in tradable sectors. 　 ⇒Intrinsic inflation persistence is larger in non-tradable sector than in tradable sector. The coefficients on backward-looking terms in tradable sector are varied with relatively narrow range. The coefficient on backward-looking terms in non-tradable sector are varied with relatively wide range from 0.59 (Italy) to 0.84 (Germany). ⇒The differences in intrinsic inflation persistence in non-tradable sector would contribute to the inflation differentials among countries. 11/27-28/2008 EMU: 10 years of Success?

Empirical Results New Keynesian Phillips curves: extrinsic persistence The coefficients on domestic output gap are smaller in non-tradable sectors than in tradable sectors. ⇒Extrinsic inflation persistence in non-tradable sector is larger than that in tradable sector. 11/27-28/2008 EMU: 10 years of Success?

Impulse Response Function France Germany Italy Netherlands Spain 11/27-28/2008 EMU: 10 years of Success?

Impulse Response Function Inflation rates of non-tradable react less to the interest rate shock than inflation rates of tradable goods. There exist differences in effect of monetary policy on inflation rates among the euro area countries. Ex. Following the tightening of money market interest rate, inflation rate in Italy decreases more largely, inflation rate in France does not revert to the initial level rapidly. 11/27-28/2008 EMU: 10 years of Success?

Conclusion We found the evidence of and - convergences not for both total inflation rates and inflation rates of non-tradable goods but for inflations rate of tradable goods. Both intrinsic and extrinsic persistences are larger in non-tradable sectors than in tradable sectors. The degree of intrinsic persistence is different among countries. => The differences in inflation persistence in non-tradable sector contribute to the inflation differentials among the euro area countries. Non-tradable inflation rates react less to the interest rate shock than tradable inflation rates. There exist differences in effect of the single monetary policy on inflation rates among the euro area countries. 11/27-28/2008 EMU: 10 years of Success?