6533b85efe1ef96bd12c0616

RESEARCH PRODUCT

Competition and inflation differentials in EMU

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In a monetary union, inflation rate differentials may be substantial over the business cycle. This paper parameterizes a two-country monetary union in which different economic structures in the two countries generate temporary inflation differentials. Cross-country differences are introduced in (i) the elasticity of demand in the goods markets, which cause producers to discriminate prices, (ii) the degree of price inertia and (iii) the degree of openness or preference for foreign goods in consumption. The model is calibrated to reproduce two average large EMU countries and it is able to generate such inflation differentials. We find the mechanism of price discrimination quantitatively more important than the differences in price inertia. Moreover, under asymmetric shocks, differences in the degree of openness such as those observed within the EMU can have sizeable effects on the dispersion of inflation rates.