Inflation Differentials in New EU Member States: Empirical Evidence

In this paper, the authors examine the determinants of inflation differentials in a panel of the new European Union member states vis-a-vis the euro area in 1997–2007. Their main results are as follows. Exchange rate appreciation and a higher price level in the new EU members is associated with a narrower inflation differential vis-a-vis the euro area, while a fiscal deficit and a positive output gap seem to contribute to a higher inflation differential. Nevertheless, the effect of price convergence on inflation differentials is found to be dominant in these countries, suggesting that a country with a price level 20 % below the euro area average is likely to exhibit inflation nearly one percentage point above that in the euro area. Overall, the authors´ results indicate that real convergence factors rather than cyclical variation are more important for inflation developments in the new EU members as compared to the euro area.