The Divergence of Price Levels in the European Union

Until the global financial crisis of 2007-08, inflation differentials in the euro area could beexplained by a general trend towards price level convergence; that is, countries with lowerprice levels tended to have higher inflation rates than countries with higher price levels.Since then, however, the trend has reversed: price levels in the euro area are now diverging.Time series analyses suggest that this divergence is not temporary but, rather, has beenanchored in the time series process of price levels all along. This is true not only for theaggregate of the harmonised index of consumer prices but also for sub-aggregates oftradable goods. A potential explanation for these findings could be attributed to monopolisticprice discrimination. Empirical studies have documented the significant role played byprice discrimination based on per capita income in international trade. The price levels ofthe member states of the Economic and Monetary Union indeed display a clear positivecorrelation with GDP per capita. Furthermore, real GDP per capita between the member statesof the monetary union is also diverging and - as to be expected in the case of a positivecorrelation between real GDP per capita and price levels - the divergence of nominal GDPper capita is larger than the divergence of real GDP per capita. This article describes theseempirical findings, outlines possible explanations for them and discusses various options forresponsive economic policy action.