EMU enlargement and convergence of pricelevels: Lessons from the German reunification

We analyse the possible impact of EMU enlargement on inflation rates in the ac-cession countries. We establish two main points: first, using a theoretical model we show that if large initial differences in price levels occur, even under very favourable circumstances the optimal path for price adjustments should be asym-metric, i.e. occuring mostly in the candidate countries. Second, based on data from the German reunification we quantify the inflationary effect of price level convergence in the accession countries. Our findings indicate that (trend) inflation rates in the EMU candidate countries are likely to increase sharply, whereas the impact on the current euro area is likely to be small, albeit not negligible. Our results support the need to allow for some flexibility in the exchange rate arrangements with the candidate countries to facilitate gradual price level convergence prior to EMU enlargement.