Is There Scope for Inflation Differentials in EMU? An Empirical Evaluation of the Balassa-Samuelson Model in EMU Countries

The Balassa-Samuelson (BS) model is evaluated in eight of the eleven EMU countries. This model suggests that productivity differentials between traded and non-traded goods sectors generate sectoral inflation differentials (dual inflation). Furthermore, differentials in the degree of dual inflation induce inflation differentials between countries. The standard BS model implies a cointegration relationship between relative prices and sectoral productivities. While this link generally seems to exist, the magnitudes of the parameter estimates are not in accordance with the theoretical model in most countries. As the presumed uniformity of sectoral wages is rejected in most cases, relative wages were allowed to enter the estimation. This extended BS model is endorsed by the data in every country. Simulations based on these results were carried out to quantify possible inflation differentials. Setting EMU-wide inflation equal to 2 per cent and assuming that PPP holds for traded goods, the projected inflation varies around the EMU-average within a margin of some +/-1 percentage points across the countries.