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This paper analyzes past and potential inflation differentials for current EU Member States and theacceding countries. Although inflation differentials decreased significantly over the last ten years or sowithin the EU-15/EU-12 and the acceding countries, they are still on top of the policy agenda. Indeedthere are a number of potential causes of inflation differentials. They range from cyclical factors via theexchange rate pass-through and oil price shocks to differences in productivity advances and changes inindirect taxes. Regarding the impact of these factors on inflation, a number of similarities can be foundacross countries. At the same time, because differences exist, e.g. in the cyclical position, the degreeof openness, oil intensity or dependency as well as price and productivity levels, inflation differentialsare not likely to vanish completely in the future. We also argue that the often cited catching-up factors,such as the Balassa-Samuelson effect, seem to be considerably weaker than generally believed. Inaddition, inflation differentials could be clearly associated with inappropriate national fiscal and struc-tural policies.

1 IntroductionIn April 2003, a Big Mac atMcDonald�s cost, according to TheEconomist�s Bic Mac index, in the euroarea EUR 3.24, and the correspond-ing price in Denmark was EUR4.47. At the same time, one had topay only about half when buying thesame very standardized product inSlovakia, Hungary, Poland, Estonia,Lithuania or the Czech Republic.2

This phenomenon reflects not onlythe substantial undervaluation of theacceding countries� currencies interms of purchasing power paritybut also roughly illustrates differencesin price levels and in relative prices.

In general, different price levelsmay result in differing inflation rates.This phenomenon can be observednot only across countries but alsoacross regions, cities or even city dis-tricts. The reasons for inflation differ-entials can indeed be manifold: Theymay be the outcome of different cy-cles, noncompetitive market struc-tures, structural rigidities, differentconsumer preferences or cost struc-tures and depend on the location(e.g. transportation costs, local taxes).They can be supply or demand driven.

In the long run, however, there areseveral mechanisms working into theopposite direction, helping reducethese differentials. In the EuropeanUnion these are for instance the com-pletion of the internal market, the re-duction of subsidies, the dismantlingof structural rigidities and, most re-cently, the introduction of the singlecurrency.

In the European Union (EU), in-flation differentials had not been amajor issue for decades. They hadmore or less been taken for granted,given that the Community had alwaysincluded both highly industrializedcountries and catching-up countries.But the existing inflation differentialswere not only the outcome of differ-ent levels of economic development;they also reflected different economicpolicies. In wage policies, one exam-ple was Italy with its scala mobile,which kept wage-price spirals going,instead of limiting wage increases toproductivity gains. As to exchangerate regimes, there was the hard-currency bloc, which successfullymaintained price stability most ofthe time, and, on the other hand,there were those countries which

1 [email protected], [email protected], [email protected] Slovakia: EUR 1.92; Hungary: EUR 2.38; Poland: EUR 1.77; Estonia: EUR 2.26; Lithuania: EUR 2.25;

Czech Republic: EUR 2.14. Source: www.economist.com/markets/Bigmac. The prices provided in USD areconverted in euro using the EUR/USD exchange rate as of April 2003.

Bala«zs E«gert,DorisRitzberger-Gru‹nwald,Maria AntoinetteSilgoner1)

Monetary Policy & the Economy Q1/04 47�

Inflation Differentials in Europe:Past Experience and Future Prospects

were aiming to gain competitivenessby depreciating their currencies and,as a result, were faced with two-digitinflation rates. Although this policyhad adverse effects on the main trad-ing partners, the resulting inflationdifferentials as such were not a majorpolicy concern.

In the beginning of the 1990s,when the idea of a monetary unionwas taking shape, inflation differen-tials became a matter of widespreadconcern. How can this sudden interestbe explained? In a monetary unionthere is only one interest rate, whichis set on the basis of an area-wide as-sessment of economic conditions. Ifthe level of inflation is found to devi-ate from the desired level in individualcountries, it has to be dealt with usingcompletely different instruments, forinstance fiscal or structural policymeasures, at the national level.

Whether or not a monetary uniondoes become a success story dependson several conditions. On a general ba-sis, the more member states trade witheach other, the larger the gains arefrom eliminating nominal exchangerate fluctuations. Nevertheless, in theabsence of synchronized business cy-cles among member states and becauseof asymmetric demand and supplyshocks, the costs of irrevocably fixingthe currency may exceed the gainsstemming from an increased stabilityof the business environment. However,business cycles should get increasinglysynchronized after the launch of thecurrency union if intra-industry tradeis sufficiently high among memberstates and capital and labor factormobility can help member states to ad-just to asymmetric shocks. Hence, itappears that high intra-industry trade,efficient capital and flexible labor mar-kets are key to a smoothly functioningmonetary union.

In the run-up to Economic andMonetary Union (EMU), when infla-tion rates were squeezed, inflation dif-ferentials became smaller, too. Thereason was a more stability-orientedoverall macroeconomic policy, includ-ing, for instance, a restrictive fiscalpolicy to meet the fiscal convergencecriteria, a productivity-oriented wagepolicy as well as participation in theexchange rate mechanism.

Recently several studies by inter-national institutions (IMF, 2001 and2002, OECD, 2002) expressed con-cern about widening inflation differ-entials in the years since the beginningof EMU. The present study in a firststep reassesses the past evolution ofinflation differentials in the euro areaand investigates the possible underly-ing reasons. Several recent studiesdeal with the phenomenon of inflationdifferentials in highly industrializedcountries (ECB, 2003), but they usu-ally do not refer to EU enlargement.Since ten countries will join the EUin May 2004, it is, however, of majorinterest to assess future challenges andto broaden this investigation. Thepresent study therefore incorporatesthe acceding countries into the analy-sis. The purpose is not to judge towhat extent they already fulfill theMaastricht inflation criterion, giventhat the enlargement of monetary un-ion is not just around the corner andthere are a few other criteria to bemet. Rather, a look at inflation differ-entials will be taken within a hypo-thetically enlarged euro area with re-spect to future policy challenges.

Inflation differentials are interest-ing from a general economic pointof view because they are closely re-lated to the evolution of the real ex-change rate and thus to competitive-ness and also relevant for capitalmovements. In particular, the acced-

48 Monetary Policy & the Economy Q1/04�

Inflation Differentials in Europe:

Past Experience and Future Prospects

ing countries may have deviating infla-tion rates when compared with cur-rent euro area countries, given differ-ences in the Balassa-Samuelson effectand in the share of services and admin-istered prices in the Consumer PriceIndex (CPI).

The remainder of the paper is asfollows: Chapter 2 describes inflationdifferentials in the past by extendingstatistical measures to a hypotheticallyenlarged area of EU-15+10. Chapter 3investigates underlying reasons for in-flation differentials, such as cyclicaland external factors, and factors re-lated to the convergence of price lev-els. Finally, Chapter 4 concludes.

2 Inflation Differentials:Past Evidence

Recently there have been increasingconcerns about worrisome inflationdivergence in Europe. This sectionwill first describe the inflation differ-entials in the current euro area. In afurther step, however, a more for-ward-looking perspective is taken byalso calculating inflation divergencemeasures for a hypothetically enlargedeuro area. This will allow us a forwardview on the upcoming policy chal-lenges.

2.1 Inflation Differentials in theEuro Area

Chart 1 illustrates the change in infla-tion differentials in the euro area withseveral divergence indicators for theperiod 1990 to mid-2003. First, thespread is used, defined as the differ-ence between the highest and thelowest national inflation rates. The

spread (grey line, scale adjusted3)decreased dramatically from up to20% at the beginning of the 1990sto around 1% in mid-1999, followedby a comparatively limited increase ofinflation differentials in early 2000.Ever since then it has remained in arange of between 3% and 4%. Asthe spread is highly sensitive to singleoutliers and does not allow for aweighting of the observations, a highinflation rate in one small countrycan have a major impact on this dis-persion measure.

The standard deviation is anothermeasure of inflation differentials.The dark red line in chart 1 for the12 euro area countries tells a similarstory like the spread, although at a dif-ferent level: according to this meas-ure, dispersion decreased dramaticallyuntil mid-1999, increased thereafterand has remained stable at a level ofslightly above 1% since mid-2000. Auseful variant is the variation coeffi-cient, defined as the ratio of the stand-ard deviation to the mean of inflation.The superiority of this measure isbased on the observation that inflationdifferentials tend to increase in timesof high average inflation rates. An in-tuition is for example that the pass-through of an oil price increase willbe most pronounced in countries thatalready show overheating tendencies.The standard deviation may thereforeoverestimate the inflation differen-tials.4 The variation coefficient allowsinvestigating inflation differentials in-dependent of such scale effects. Thesmoother path of the dark blue linein chart 1 supports the assumption

3 Divided by 3.4 The use of the variation coefficient entails a statistical problem in so far as it can take huge values whenever the

average inflation rate (i.e. the denominator of the ratio) approaches zero. In the euro area, however, valuesclose to zero were not observed for the inflation rate during the sample period so that this problem is not anissue here.




of a positive relationship betweeninflation dispersion and average infla-tion. The spike around January 1999is attributable to a relatively highstandard deviation while average infla-tion was relatively low. This measureof dispersion does therefore not re-port an increase in inflation dispersionduring 1999. In the last year of oursample, however, there seems to besome level shift in the measure.

These unweighted measures arestill very sensitive to divergent devel-opments in small countries. An alter-native is to use the weighted standarddeviation and variation coefficient,which weights observations accordingto their nominal GDP. These disper-sion measures better reflect the geo-graphical dimensions and the potentialimpact on the euro area economy. Inthe case of the weighted standard de-viation (light red line) the high infla-tion dispersion in the first half of the1990s is far less pronounced, whichreveals that relatively small countriesplay a big role in inflation dispersion.The increase in the standard deviation

at the end of 1999 is now far lesspronounced and much flatter. Theweighted variation coefficient (lightblue line), the measure that takes intoaccount different sizes of the econo-mies as well as level shifts, again doesnot show any such increase but a slightlevel shift since mid-2002.

This analysis suggests that a hugepart of inflation dispersion at the be-ginning of the 1990s can be tracedto developments in relatively smallcountries. Their national inflationrates explain to a large extent the de-creasing trend in the unweightedmeasures. This leads to the conclusionthat dispersion measures that neglectcountry sizes may overestimate infla-tion differentials. The other findingis that the slight increase in inflationdispersion at the end of 1999 can beattributed to higher average inflation,reflecting sharp increases in oil prices.Taking into account this level effect,no evidence could be found for an in-creased inflation divergence at the endof the 1990s.

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2.2 Inflation Differentials in aHypothetically EnlargedEuro Area

In view of the forthcoming enlarge-ment of the EU and the envisagedadoption of the euro in the accedingcountries in the medium term, it isof interest to calculate a measure forinflation dispersion also for a hypo-thetically enlarged euro area. Chart2 shows one of the most sensible di-vergence measures — the weightedstandard deviation — for the EU-12(the euro area countries), for theEU-15 (all current EU MemberStates) and for the EU-15+10 (i.e. in-

cluding the acceding countries, dataavailable as of 1997).5 This should inno way be seen as a claim that thesecountries are ready for euro areamembership. Before adopting theeuro, they will have to achieve a highdegree of fiscal and monetary stabilityby fulfilling the Maastricht conver-gence criteria. One of these criteriacalls for an inflation rate which is nomore than1.5 percentage points abovethat of the three best performingMember States. Only those countriesthat already show a sufficient degreeof price stability will be allowed toadopt the euro.

The message that can be drawnfrom chart 2 is that the developmentof inflation differentials since mid2001 within a hypothetically enlargedeuro area does not differ substantiallyfrom the evolution of inflation differ-

entials in the 12 current euro areacountries alone. EU inflation disper-sion remained below the correspond-ing euro area measures for the majorpart of our data sample, however witha narrowing gap. The permanently

5 To be precise the EU-15+10 measures were calculated with data of 24 countries only due to the lack of HICPdata for Malta. Because of the small GDP weight of Malta this should not limit the information content of themeasures.

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lower GDP-weighted standard devia-tion for the EU-15 can be attributedto the fact that inflation rates in thethree nonparticipating EU MemberStates did not show any extreme de-velopments in the past. Since theend of the 1990s there has been nosignificant difference between thetwo measures.

For the EU-15+10 the dispersionmeasure was significantly higher be-tween 1997 and 2001, when the ac-ceding countries still experiencedtwo-digit inflation rates. Since the be-ginning of data availability for the ac-ceding countries in 1997, a huge dis-inflation process has taken place. Theweighted standard deviation of infla-tion rates within all acceding countriestaken together decreased from morethan 5% in the first half of 1997 toaround 2% since mid-2001. At thesame time, the average inflation ratein the acceding countries droppedfrom more than 14% in January 1997to less than 2% at the beginning of2003. It is noteworthy that in mid-2003 the Czech Republic, Lithuaniaand Poland had lower inflation ratescompared with the best performingEU Member States, such as Germany,the U.K. or Belgium. Although someof the acceding countries presentlystill show above-average inflationrates, the relatively small GDP weightof the upcoming EU Member Statesexplains the small influence on theoverall dispersion measure.6

To sum up, measures accountingfor country weights apparently donot support the claim of some inter-national institutions that euro area in-flation differentials have pronouncedlyincreased since the beginning of mon-etary union. A look at measures for

inflation differentials within a hypo-thetically enlarged euro area revealsa relatively minor impact on the infla-tion differential of the EU-15 in therecent past. During the past 15months, inflation differentials asmeasured by the GDP-weightedstandard deviation were very similarno matter whether they were basedon EU-12, EU-15 or EU-15+10 data.In the case of the acceding countriesthis can also be attributed to theirsmall GDP weights.

3 Inflation Differentialsand Their UnderlyingReasons

This chapter reviews the major theo-retical arguments why inflation ratesmay deviate permanently or tempora-rily within a given group of countries.As the issue of inflation differentials isof major policy relevance only withina group of countries participating in acurrency union, we will consider thecurrent euro area as the benchmarkfor our analysis. We will give an over-view of the various factors causing in-flation differentials in the euro areaand discuss their present and futurerelevance. In some selected cases wewill also refer to the generalizationof our results to the whole group ofcurrent EU countries.

While there are many studies aboutinflation differentials and their possibleunderlying reasons in the current EUMember States or the euro area coun-tries, there are almost no such studiescovering the acceding countries.Therefore we assess the role factorsunderlying inflation differentials playin the acceding countries comparedto the current euro area and what rele-vance they will have in the future.

6 In 2002 the nominal GDP of the acceding countries put together amounted to only 4.8% of euro area GDPand to 6.2% of EU GDP.




Section 3.1 assesses the cyclical di-mension of inflation differentials. Un-less business cycles are fully synchron-ized, differences in the cyclical posi-tion will translate into inflation dis-persion. Section 3.2 examines thetwo main external factors that canlead to increased divergence in infla-tion developments: oil price shocksand exchange rate fluctuations. Sec-tion 3.3 finally considers factors re-lated to price level convergence andto different developments of adminis-tered prices or taxes.

3.1 Cyclical FactorsThe cyclical position of an economy isone major factor in inflation develop-ments. This is illustrated in chart 3,which relates the most common meas-

ure for the cyclical position, the out-put gap (defined as the deviation ofactual output from potential GDP as apercentage of potential GDP), to theEU inflation rate. The clearly visibleco-movement confirms the close rela-tionship of these measures.

For a panel of 11 EU countries(EU-12 without Luxembourg) thisvisual result is confirmed by regress-ing yearly national inflation rates(measured by the CPI) for the period1971 to 2001 on the output gap. Thefirst column in table 1 shows a positiveand highly significant coefficient, indi-cating that output gaps play an impor-tant role in inflation developments inthe euro area.7 The same exercise car-ried out for the EU countries producesimilar results.

As long as business cycles within agroup of countries are not perfectlysynchronized, deviating cyclical move-ments will be a fundamental cause ofinflation differentials. Within a mone-tary union monetary policy can no

longer be used as an instrument to sta-bilize national inflation rates; rather,adverse inflation developments haveto be addressed by national economicand fiscal policies. Without any suchactions, the move of a group of coun-

7 The coefficient of the output gap is positive throughout the models presented in columns 1 to 4, it is however,not significant in the last model as long as we allow for fixed country effects. The reason is the relatively lowvariability of the output gap variable compared to the other variables in the model so that the fixed effectspecification picks up most of its explanatory power.

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tries to a monetary union can in prin-ciple be assumed to lead to a higherdegree of cyclically induced inflationdifferentials. The theory about the en-dogeneity of optimal currency areacriteria, however, says that — providedintra-industry trade is high enough —business cycle synchronization in-creases for a group of countries partic-ipating in a monetary union so that theimportance of cyclically caused infla-tion differentials should play a decreas-ing role.

Chart 4 shows the evolution of thestandard deviation of annual outputgaps for the 12 euro area countries.The fact that output gap dispersionhas remained at a relatively moderatelevel since the run-up to the commoncurrency could indicate such a nar-rowing of cyclical developments. Ifthis observation continues, the roleof inflation differentials should de-crease. So far, however, a structuralbreak in the series cannot be detectedwith econometric tools.

As regards the acceding countries,there seems to be an emerging viewaccording to which business cyclesare getting increasingly synchronizedwith those of the euro area. AlthoughBabeckii et al. (2002), Fidrmuc andKorhonen (2003) and Korhonen

(2003) show the presence of asym-metric demand and supply-side shocksin some of the acceding countries,Frankel and Rose (1998) take the viewthat symmetric shocks are likely todominate after the formation of an en-larged monetary union. Actually,Fidrmuc (2001) demonstrates that be-sides bilateral trade intensity the pre-condition of the endogenous conver-gence of business cycles is a high shareof intra-industry trade in total trade.Hence, increasing business cycle syn-chronization can be explained by thefact that some acceding countries suchas the Czech Republic and Hungaryhave high intra-industry trade vis-a‘-vis the euro area. In contrast, coun-tries with lower intra-industry trade,such as Latvia, Lithuania and Poland,may experience less synchronization.

3.2 External FactorsThe two most common external fac-tors that can have a dramatic impacton inflation rates are changes in theexchange rate and oil price shocks.This section first provides evidencethat these two factors matter for infla-tion and then discuss arguments whythis effect may differ considerablyacross countries so that it can also ex-plain part of inflation differentials.

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3.2.1 Exchange Rate Pass-ThroughAn important external factor that af-fects inflation rates are changes inthe nominal exchange rate. This canbe referred to as the exchange ratepass-through. Indeed, changes in thenominal exchange rate first impacton import prices, and this effect sub-sequently feeds into prices of domes-tic tradable goods and finally into abroad set of price groups and intooverall inflation. The extent of thepass-through depends on the share ofimported final goods and the shareof imported intermediate goods indomestically manufactured goods.But expectations are also bound toplay an important role: changes inthe exchange rate viewed as perma-nent are likely to have longer-lastingeffects on prices in contrast to changesconsidered to be transitory. In addi-tion to this, it has been shown recentlythat the larger the change and thelower the volatility of the nominalexchange rate, the higher the pass-through will be.

The second column in table 1 esti-mates the effect of a change in thenominal effective exchange rate(NEER henceforth) — a syntheticmeasure that weights the bilateral ex-

change rates according to the tradeweight of the respective country —on inflation rates in euro area coun-tries. The negative and significant co-efficient indicates that a nominal ap-preciation/depreciation of the NEERwill have a negative/positive impacton inflation. The estimated coefficientbelow unity corroborates earlier stud-ies (see Goldberg and Knetter, 1997,for a review of the literature). Themain factor behind this incompletepass-through is third degree pricediscrimination8 in the markets, i.e.market segmentation. According toDarvas (2001), this is mainly due totransportation costs, tariff and non-tariff barriers, considerable differen-ces of even highly homogenous goods,home or brand loyalty, the presence ofmultinational firms and cross-borderintra-firm trade.

Not only asymmetric exchangerate shocks but also those that occursimultaneously across countries couldlead to changes in inflation differen-tials. Columns 3 and 4 in table 1 indi-cate that the openness of an economy,defined as the sum of exports andimports of goods divided by GDP, isan important factor determining theexchange rate shock pass-through. In

8 First degree price discrimination is when for every consumer the highest price he/she is willing to pay ischarged. Second degree price discrimination refers to prices being determined in terms of sold units of theproduct. Under third degree price discrimination, different prices are charged for different segments of themarket characterized by differences in e.g. geographical location, age and sex.

Table 1

Determinants of Inflation Rates1)

Variable 1 2 3 4

Output gap 0.136*** 0.091* 0.102** 0.059Change in exchange rate �0.292*** �0.029Change in exchange rate x openness �0.003*** �0.003***Oil inflation 0.016*** �0.009Oil inflation x oil dependency 0.165*** 0.118***Oil inflation x oil intensity 0.003*** 0.003***Observations 359 326 285 285R2

adj 0.29 0.47 0.46 0.46

Source: Eurostat, OECD, IMF, IEA.1) Columns (1) and (2) based on all euro area countries except Luxembourg for the period 1971-2001. Columns (3) and (4) also without Greece.Fixed effects.

Note: *** (**) [*] denotes significance at the 1% (5%) [10%] level.




2002, openness ranged from less than50% in Italy, Spain and France tomore than 100% in Belgium and Ire-land.

Provided that the European inte-gration process leads to a further in-tensification of intra-EU trade and adecrease in market segmentation, theimportance of exchange rate shockson inflation rates and inflation differ-entials is expected to diminish. Withregard to the acceding countries, theexchange rate pass-through shouldplay an important role because mostof them are very open economies,withopenness ratios ranging from 74% inLatvia to about 130% in Estonia andSlovakia in 2002. Poland is a relativelyclosed economy with an opennessratio of roughly 50%. However, theempirical literature is rather mixedin this regard. Whereas Christoffersenet al. (2001) and Przystupa (2002) es-timate the exchange rate pass-throughto be strong in the acceding countries,Ganev et al. (2002) show that the linkbetween changes in exchange ratesand inflation rates was anything butstable in Hungary and Poland in thelate 1990s. Results in Darvas (2001)suggest that in 2000 the degree ofthe pass-through from the exchangerate to overall inflation ranged from15% to 40% in the Czech Republic,Hungary and Poland.

Given high overall openness, andsince in all acceding countries, exceptfor Lithuania, the share of trade withthe EU in total trade was more than50% — and as high as 65% in Hun-gary — in 2002, the adoption of theeuro would in the future considerablydampen inflation differentials causedby exchange rate shocks between theacceding countries and the currenteuro area countries.

3.2.2 Oil Price ShocksOil price shocks have an impact on theinflation rate that materializes in sev-eral �waves.� Oil prices have a directfirst-round effect on the energy com-ponent of consumer price inflation. Away to evaluate the average delay ofthe effect of oil price developmentson energy prices is to determine thelag length at which the correlation co-efficients between the oil price andthe energy price inflation series ishighest. Following this approach weget an estimated lag of three monthsfor the euro area. There is, however,evidence of the asymmetry of the laglength: While the pass-through of pos-itive oil price shocks on energy pricestakes place almost instantaneously (lagof one month), the estimated laglength is eight months in the case ofdecreasing oil prices. Transport costswill also almost immediately react tooil price changes. Examples of pricegroups that show indirect or delayedfirst-round effects of oil price shocksare producer prices (estimated laglength nine months) or prices for non-energy industrial goods (more thantwo years). As second-round effectswe finally understand the delayedpass-through of oil price changes onconsumer price inflation through theresponse of wages.

The second column in table 1shows evidence of this positive andsignificant impact of oil price changes(in national currency) on inflationrates. It is noteworthy that the esti-mated coefficient is fairly low. Thiscan be put down to the fact that taxesaccount on average for up to 70% offuel prices in the euro area and thusplay a buffer role in passing oil pricechanges onto consumer prices.

Having shown the importance ofoil price developments for changesin inflation, we now turn to the — at




least — three ways in which oil priceshocks can contribute to inflation dif-ferentials. First of all, oil price in-creases can be passed through ontoconsumers more easily under strongeconomic conditions. This impliesthat countries with higher positiveoutput gaps may also experience aquicker oil price pass-through, so thatinflation differentials may increase.The other two channels relate to acountry�s oil dependency ratio, de-fined as the ratio of net oil importsto GDP, and to the oil intensity ofproduction, defined as industry oilconsumption divided by industrialproduction. The more a country de-pends on external energy supply andthe more energy intensive its produc-tion is, the higher the oil price effecton inflation will be. These effects areexamined in columns 3 and 4 oftable 1. The signs and significancelevels of the coefficients indicate thatthe oil dependency ratio and the oilintensity of production are relevantfactors explaining the speed of theoil price pass-through. In 2001 oildependency ratios ranged from 3%in the United Kingdom and Denmark

to 13% in Greece, Portugal and Spain.Oil intensity ratios were lowest inLuxembourg (39%) and Finland(56%), countries with a highly serv-ice-based production structure, andhighest in Belgium (148%) and theNetherlands (117%). The further tothe right upper corner countries arein chart 5, the more their inflationrates depend on oil price changes.

Chart 5 illustrates the relevance ofoil price developments for inflationrates in the acceding countries.9 Allthe acceding countries are heavily de-pendent on oil imports comparedwith the EU average. The oil depend-ency ratio exceeds the respectivenumbers of EU countries in the caseof Lithuania, Cyprus, Latvia, theCzech Republic and Estonia, whilein the Slovak Republic, Poland,Slovenia and Hungary, it is compara-ble to that found in the EU catching-up Greece, Spain and Portugal. Onthe other hand, oil intensity is equalto or slightly below the EU averagefor all acceding countries except forSlovenia, Latvia and Cyprus.

The future sensitivity of inflationand inflation divergences to oil price

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shocks will depend on the further dis-entanglement of oil demand fromGDP growth. Technological progress,the shift from the industry to the serv-ice sector, the development of newenergy sources as well as energy-sav-ing measures are key factors in this re-spect. The need for improvement stillseems to be huge, especially in the ac-ceding countries.

3.3 Price Level ConvergenceThere is a group of factors that are allrelated to price level convergence. Ifprices expressed in a common cur-rency are initially different acrosscountries, convergence to a commonprice level implies higher inflation incountries with initially lower prices.Section 3.3.1 deals with price levelconvergence with a special focus ontradable goods. In this case conver-gence is a direct consequence of prog-ress towards a single European mar-ket. Trade liberalization and the com-pletion of Stage Three of EMU arewell in progress and should thereforebe of transitory nature. Section 3.3.2summarizes evidence of the Balassa-Samuelson effect that works throughconvergence of nontradable goodsprices. As this phenomenon is relatedto the gradual process of convergenceof productivity, the impact on infla-tion differentials can be assumed tobe of longer-term importance. Sec-tion 3.3.3 takes a look at the relativeweights of HICP subgroups withinthe overall index. Sections 3.3.4 and3.3.5, finally, assess the importanceof regulated and administered pricesas well as taxes for inflation differen-tials.

3.3.1 Price Level Convergencefor Tradable Goods

Differences in price levels may pro-vide a potential explanation for di-

verging inflation developments in Eu-ropean countries. If price levels are in-itially different across countries, con-vergence towards a common pricelevel implies higher inflation rates incountries with initially lower pricelevels during the transition period.The driving force behind price levelconvergence is the progress towardsa single European market, rangingfrom trade liberalization to the adop-tion of the single currency. Whilethe first factor should already havematerialized to a large extent for thecurrent EU Member States, there isstill further convergence to be ex-pected through increased transpar-ency following the introduction ofthe common currency.

To compare price levels in differ-ent countries, Rogers (2001) con-structs a proxy for the price level ineach country. For this purpose, datais obtained from the Economist Intel-ligence Unit, which has calculated acost-of-living index for major citiesworldwide since 1981 on a yearly basisby directly recording local prices ofspecific goods like bread, a pair of bluejeans, a haircut or the rent of an apart-ment. The aggregated price level data— based on actual prices of 168 goodsfor 26 cities in 18 countries — provideevidence in favor of price level conver-gence in Europe. Between 1990 and1999 prices became less dispersed inthe euro area. Convergence was espe-cially evident for tradable goods andstronger in the first half of 1990s.The statistically significant and robustnegative relationship between 1999price levels and the 2000 aggregate in-flation rate in Europe may indicatethat price level convergence is an im-portant factor in explaining inflationdifferentials also for more recent data,especially for the low-price countriesGreece, Portugal and Spain.




Obviously, price levels for majorcities cannot be viewed as representa-tive for the national price level. Amore appropriate data set can be ob-tained from the International PriceComparison program launched underthe aegis of the United Nations duringthe 1970s, which provides a uniquedataset of price levels. Price levelsof the EU Member States and theacceding countries are calculated byEurostat on the basis of price data ofreasonably comparable goods andservices, expressed in terms of theEU-15 average. Chart 6 shows thatin 2002 there were still substantial dif-ferences in price levels across the euroarea. A closer look reveals that thesedifferences can be observed basicallybetween three homogenous sub-groups of euro area countries: thecountries with the highest relativeprice level, Luxembourg, Ireland andFinland, the second group, denotedas the core countries group, consistingof Austria, Belgium, France, Germanyand the Netherlands, which exhibitvery similar price levels with a maxi-

mum deviation of 6.5%, and finallythe group of Mediterranean coun-tries, Italy, Spain, Greece and Portu-gal;10 the latter have price levels thatare by up to 25 percentage pointslower than the EU average.

Regarding the acceding countries,chart 6 reveals a huge gap betweenthem and the euro area.11 The pricelevel of most acceding countries is halfas high as in the euro area. An excep-tion is Cyprus, whose price level iscomparable to that of the Mediterra-nean EU countries.

Based on a Eurostat dataset includ-ing roughly 40 components of theoverall price level, we classify pricesinto six categories: durable goods,semidurable goods, foods, marketand nonmarket services and real estateprices. Based on the same four groupsof countries like chart 6, table 2 showsthat goods prices are highest in group1and provides some evidence for pricelevel convergence for durable goods.Note also that prices of durable goodsseem comparable also for the accedingcountries. However, it turns out that

10 It should be mentioned that Italy is somewhere between group 2 and 3. As we will see, in some respect, Italycould be assigned to group 2 whereas in other cases, it shows more similarities with the other MediterraneanEU Member States.

11 Data for Malta are not available.

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prices deviate the least among thecore countries, i.e. Austria, Belgium,France, Germany and the Nether-lands. By contrast, in the case of theSouthern European countries, intra-group differences are by far highercompared with the core countries.

At the same time, the price levelof semidurable goods and foods is stillconsiderably below the EU-15 averagein Greece, Italy, Portugal and Spain.One reason for this might be that theirprice level is determined to a greaterextent by local conditions, given thatthese goods are less tradable interna-tionally and more labor intensive andhave a larger service component. Asa consequence, in countries withlower wage and service price levels,such as Greece, Italy, Portugal andSpain, prices for this kind of goodsare also lower. Finally, the patternsemerging for the Southern Europeaneuro area countries are all the moretrue for the acceding countries. Forinstance, for semidurable goods andfoods, the price level in the most ex-pensive euro area country is roughlytwice as high as in the cheapest CEEacceding country.

3.3.2 Price Level Convergence forNontradable Goods:The Balassa-Samuelson Effect

Let us now turn to the price level ofnontradables, more specifically toservices. In general, service pricesare believed to be more dispersed thangoods prices. This seems to be con-firmed in table 3, which shows devia-tions as high as 91% and 138% in non-market services and property prices,respectively, throughout the entireeuro area. As in the case of goods pri-ces, there is a relatively high price ho-mogeneity within groups 1 and 2 andhigher dispersion across Southern Eu-ropean countries. It is noteworthy thatprices of market services are strikinglysimilar across the core countries andwithin group 1. But more impor-tantly, the price level of both marketand nonmarket services is by about20% lower in the Southern Europeancountries compared with other euroarea countries. This also holds truefor property prices, which differ bymore than 30%.

In the acceding countries, marketservice prices were half as high as inthe euro area, and the difference innonmarket services and property pri-ces is even larger: The difference be-tween the highest and the lowest pricelevels amounts to 185% for market

Table 2

Relative Price Levels of Goods and Maximum Deviations, 20021)

Group 1 Group 2 Group 3 EU-12 CEEC-8 EU-12 +CEEC-8

Average price level relativeto the EU-15 average (EU-15 = 100) %

Durable goods 110.0 101.5 99.0 x 88.7 xSemidurable goods 108.3 102.8 89.1 x 68.2 xFood 115.0 99.2 90.2 x 68.5 x

Maximum price level overminimum price level within the group percentage points

Durable goods 0.18 0.05 0.16 0.27 0.19 0.44Semidurable goods 0.32 0.20 0.21 0.55 0.53 2.52Food 0.19 0.13 0.19 0.51 0.45 1.78

Source: Authors� own calculation based on data obtained from Eurostat.1) Group 1: Finland, Ireland, Luxembourg; Group 2: Austria, Belgium, France, Germany, the Netherlands; Group 3: Greece, Italy, Portugal, Spain;CEEC-8: CEEC-5+3 Baltic countries.




services and is as large as 330% and358% for nonmarket services andproperty prices, respectively.

All this leads us to conclude that atpresent, the euro area is composed ofa core region, i.e. group 2, and agroup of countries (group 3) that isstill in a catch-up phase. Besides, thereare some outliers such as Finland, Ire-land and Luxembourg. The adoptionof the euro by the acceding countrieswould lead to more heterogeneitywithin the euro area: in addition tothe core countries, two groups ofcountries at different stages in thecatch-up process would emerge.

The Balassa-Samuelson (BS) effectis one popular explanation for differen-ces in service prices. Let us assume acountry with two sectors, an open sec-tor producing tradable goods and aclosed sector producing nontradablegoods. Given that wages are assumedto be linked to labor productivity inthe open sector and because wagesare expected to equalize across sec-tors, the price level of the closed sectoris determined by the productivity levelprevailing in the open sector. This isone reasonwhy in countrieswith lowerproductivity levels in the open sectorservice prices tend to be lower.

Table 3

Relative Price Levels of Services and Maximum Deviations, 20021)

Group 1 Group 2 Group 3 EU-12 CEEC-8 EU-12 +CEEC-8

Average price level relativeto the EU-15 average (EU-15 = 100) %

Market services 105.6 102.9 81.1 x 55.5 xNonmarket services 110.8 101.5 83.2 x 41.3 xProperty prices 113.2 106.4 68.6 x 41.5 x

Maximum price level overminimum price level within the group

percentage points

Market services 0.03 0.08 0.23 0.48 0.56 1.85Nonmarket services 0.10 0.23 0.69 0.91 1.34 3.30Property prices 0.28 0.30 0.54 1.38 0.62 3.58

Source: Authors� own calculation based on data obtained from Eurostat.1) Group 1: Finland, Ireland, Luxembourg; Group 2: Austria, Belgium, France, Germany, the Netherlands; Group 3: Greece, Italy, Portugal, Spain;CEEC-8: CEEC-5+3 Baltic countries.

Table 4

Inflation Due to the Balassa-Samuelson Effect

Austria Belgium Germany Spain Finland France Greece Ireland Italy Nether-lands

Portugal

percentage points

Alberola-Tyrva‹ inen (1998)1975—1993/96 1.8 3.1 1.3 3.1 2.4 1.7 x x 2.4 2.3 x1985—1993/96 1.5 2.7 1.3 3.5 1.5 1.6 x x 2.4 2.1 xSwagel (1999)1960—1996 x 1.7 0.3 x 1.4 0.2 0.8 x 1.8 0.5 2.01990—1996 x 0.2 0.0 x x �0.2 1.7 x 1.4 0.4 1.2Aitken (1999)Forecast based on 1993—1996 x x x x x x x 2.9 x x xSinn-Reutter (2001)1987—1993/95 1.4 0.8 x 1.5 2.4 1.3 x 2.4 1.5 1.4 0.81991/1995—1997/99 x x x x x x 4.3 x x x xCanzoneri et al. (2002)1973—1991 1.2 2.4 x 1.5 1.0 1.1 x x 2 x x1973—1997 0.8 1.6 x 1.4 1.6 1.4 x 1.8 x xLommatzsch-Tober (2003)1995—2002 1.5 1.0 0.1 0.4 1.2 1.5 �0.1 2.6 0.5 0.6 �1.0AVERAGE 1.4 1.7 0.6 1.9 1.6 1.1 1.7 2.6 1.7 1.2 0.8

Source: Authors� own calculations based on the original papers.




Further to this, in the event thatproductivity growth is higher in theopen sector due to catching up, unitlabor costs and thus also prices willconsequently increase faster in theclosed sector. This implies that infla-tion rates will be higher the morepronounced productivity differentialsare between sectors in any country.In the long run, the importance ofthe BS effect should slowly diminishin parallel to the progress of catch-ing-up.

Table 4 summarizes the existingevidence in the literature on the mag-nitude of the BS for the euro area.There seems to be a common under-standing that the magnitude of the ef-fect tends to be slightly higher in thetypical catching-up countries such asSpain and Greece. Notwithstandingits catching-up country status, the BSeffect turns out fairly weak in Portu-gal. On the other hand, Belgium, Fin-land, Ireland and Italy record above-average inflation rates imputable toproductivity growth. However, basedon the most recent dataset taken fromthe studies summarized in table 4,Lommatzsch and Tober (2003) sug-gest that the BS effect is strikingly

weak in Greece, Portugal and Spain,whereas it is found high in low-infla-tion countries such as Austria, Bel-gium, Finland and France.

The BS effect has become verypopular in explaining high inflationrates in the acceding countries.Table 5 summarizes the currentlyavailable estimates of the size of do-mestic inflation that can be attributedto the BS effect. A first strand ofpapers supports the view that produc-tivity-induced service inflation, esti-mated to amount to up to 9%, hasbeen at the root of high inflation inthe acceding countries. However, re-cent research has demonstrated thatthis structural inflation is considerablylower. It amounts to only up to 3 per-centage points in Hungary, Poland,Slovakia and Slovenia and to less than1 percentage point in the Czech Re-public and the Baltic States. The esti-mates show that the size of the BSeffect differs substantially across theacceding countries. The reason forsuch a low BS effect in the accedingcountries is mainly the low share ofservices in the CPI. Hence, largerproductivity gains cannot fully feedinto overall inflation. But at the same

Table 5

Inflation Due to the Balassa-Samuelson Effect

Czech Republic Estonia Hungary Latvia Lithuania Poland Slovak Republic Slovenia

percentage points

Backe« et al. (2003) 0.6 x 4.7 x x 9.6 x 3.7Golinelli/Orsi (2001) 4.3 x 0.2 x x 5.1 x xRosati (2002) 1.2 2.2 4.1 x x 3.9 x 2.2Rother (2000) x x x x x x x 2.8Sinn/Reutter (2001) 2.9 3.4 6.9 x x 4.2 x 3.4

Flet et al. (2002) 0.2 x x x x x xMihaljek (2002) 0.3 x 1.6 x x 1.4 0.6 0.6E«gert (2003) x 1.3 x x x x x xHalpern/Wyplosz (2001) 1.2 1.2 1.2 1.2 1.2 1.2 1.2 1.2Kova«cs et al. (2002)1) 0.7 x 2.5 x x x x 1.3Kova«cs/Simon (1998)1) x x 2.2 x x x x xKova«cs (2001)1) x x 2.1 x x x x xE«gert (2002a)1) 0.8 x 2.1 x x 2 0.5 1.2E«gert (2002b)1) 0.8 x 2.0 x x 2.5 �0.1 0.1E«gert et al. (2003)1) 0.4 0.7 1.4 0.3 0.5 2.2 2.1 1.3

Source: Authors� own calculations based on the original papers.1) The inflation differentials originally computed against Germany are corrected using 0.6% from table 4.




time, its size is comparable to that inthe euro area.

A closely related issue is wageflexibility, given that one of the pre-conditions for the BS effect to workis wage equalization between the openand closed sectors. In theory, the pres-ence of strong and well-establishedtrade unions enforces equal wage in-creases across sectors. Riboud et al.(2002) analyzed institutional reformsand the labor market performance inthe CEECs in the 1990s. Althoughthese countries have been adoptingthe set of policies and institutionscommon to EU Member States, somediversity among the CEECs persist.As a result, some countries have amore flexible labor market thanothers. However, when compared toEU and OECD members, most ofthe CEECs tend to be in the middleof the �labor market flexibility� scale.

The importance of trade unionshas been decreasing in all the CEECssince the end of the 1980s, when vir-tually 100% of the labor force wereunion members. During the last dec-ade, these countries moved away frompurely centralized wage bargainingsystems towards a more liberalizedregime of wage negotiation. Thisdevelopment was supported by a hugenumber of newly created firms in theprivate sector. Meanwhile trade uniondensity dropped in all transition coun-tries to less than 35% on average(Paas, 2002), with Slovenia on theupper end and the Baltic countrieson the lower end of the range. Inter-estingly, the coverage of collectiveagreements is not much higher thanunion membership, which can betraced mainly to the small number ofsectoral or regional level agreements.Therefore most employees in theCEECs rely on individual employ-ment contracts. This situation fosters

wage diversification and dampens theBS effect.

The relatively high labor mobilityin the CEECs on the other hand fos-ters wage equalization. This mobilityis a consequence of the fundamentalstructural change that characterizedthe transformation process in theCEECs and thereby led to a completerestructuring of labor demand. Interms of labor reallocation, the size ofthe agricultural sector has decreased.In addition, the countries have expe-rienced a process of deindustrializa-tion, while employment in the servicesector has increased. Apart from this,major shifts have also occurred withinsectors, e.g. in the manufacturingsector, which has become moreconcentrated in geographic terms(Hildebrandt and Woerz, 2004).These structural changes to someextent went hand in hand with laborreallocation across economic sectorsand the adjustment of wages, but alsowith changing patterns of labor forceparticipation and rising unemploy-ment.

3.3.3 Differing Weights in theCPI Basket

Another factor that can play a relevantrole for inflation differentials is theweight of different groups of goodsand services in the national CPI bas-ket. In the Mediterranean countriesservices have less whereas food andgoods have higher CPI shares com-pared with the rest of the euro area.The differences between the euro areaand the acceding countries are evenlarger. Table 6 reveals that the weightof services in the acceding countries isby up to 15 percentage points lowerthan the euro area average. In additionto this, it turns out that the share ofgoods, in particular of durable goods,is also smaller. By contrast, the rela-




tive weight of goods related to basicneeds such as energy and food in theacceding countries exceeds that ofthe euro area by far.

Weights represent the structure ofhouseholds� consumption expendi-ture, which in turn is closely relatedto the degree of economic develop-ment and households� preferences. Ac-cording to Engel�s Law, the higher thedisposable income, the less householdsspend on food. The generalization ofthis idea is that the higher the GDPper capita, the more households spendon services and less on foods and otherdurable and nondurable goods. This isalso the case in the euro area, wherethe share of services increased from33% to 40% between 1995 and2002. At the same time, the share ofgoods, food and energy items de-creased from 33%, 25% and 9% to31%, 21% and 8%, respectively.12

The implication of all this is thatin the event of economic convergence,the acceding countries will witness

changes in the structure of householdconsumption and thus in HICPweights, namely an increasing shareof services and a decreasing share offoods. On the other hand, however,the share of goods, and especially thatof durable goods, is particularly low inthe Baltic countries and in Poland, in-dicating the scope for a possible in-crease in relative durable consumptionand in the corresponding weights.Hence, merely changes in weightsmight lead to differences in inflationrates. However, since these changescaused by economic development willtake time,13 their effect should not beoveremphasized.

3.3.4 The Role of Regulated andAdministered Prices

Government policy can have an im-portant effect on inflation ratesthrough changes in regulated and ad-ministered prices. The former relatesto goods and services that are pro-vided by the private sector but whose

12 It should be noted that changes in weights can be decomposed into price and volume effects. For instance, theshare of services could have increased because households consumed more but also because of increases in serviceprices. All the same, the relative importance of goods in the consumer basket may be the result of relatively lessconsumption falling on these goods coupled with market liberalization leading to decreases in goods prices.

Table 6

HICP Weights in the Euro Area and in the Acceding Countries, 2002

Goods thereof Energy Food Services

Durables Semidurables Nondurables

%

Estonia 27.30 5.70 12.90 8.70 12.60 33.10 27.00Latvia 24.50 5.70 9.00 9.90 12.90 37.80 24.80Poland 26.70 4.20 9.20 13.40 14.30 35.20 23.80Slovenia 30.10 11.60 11.00 7.50 12.90 25.90 31.00Czech Republic 26.40 8.70 9.80 7.90 13.90 28.60 31.20Hungary 28.40 8.20 10.40 9.80 13.50 28.60 29.00Cyprus 34.20 12.60 13.10 8.40 7.50 23.20 35.20Euro area 31.20 11.30 11.80 8.10 8.20 20.90 39.70

Source: Eurostat/NewChronos.

13 Even if in the transition countries the CPI goods basket may change more quickly, the past adjustment ofweights in the euro area can offer some guidance on future trends. A very simple calculation based on table6 shows that in Poland it would probably take 15 years for the share of services in the basket to increase to40%, a level comparable to that in the euro area, whereas in the Czech Republic and in Slovenia, this levelwould be reached already in some 10 years� time.




prices are fixed or subject to price ceil-ings. Typical examples are housingrents, prices for books or certain food-stuffs. The latter refers to fees chargedfor services provided by the govern-ment, for example charges for a newpassport or parking fees. A large groupof products can in principle be sup-plied by both the private and the gov-ernment sector. Typical examples arefees for certain services in the healthand education sectors, prices for waterand energy supply, passenger transportfares, telecommunication rates and to-bacco prices. In these cases price ad-justments may occur following discre-tionary government decisions, but alsoas a consequence of the opening ofthese markets to competition throughprivatization.

As long as changes in regulatedand administered prices happen in asystematic manner across countriesthey should not play a major role indetermining inflation differentialswithin the euro area.14 The recentpast, however, has seen examples ofsituations where these price adjust-ments occurred in a more unsyste-matic way so that their impact on in-

flation differentials may have been sig-nificant. The first example is the liber-alization of network industries withinthe framework of the EU Cardiffprocess. As the speed of opening upthese sectors differed considerablyfrom country to country, an influenceof these privatization measures on in-flation differentials cannot be ruledout. Second, some countries may haveused adjustments of administered pri-ces in a more systematic manner inthe run-up to EMU as a tool to con-solidate their budgets or to lowertheir national inflation rates to fulfillthe Maastricht convergence criteria.The third example of an increased roleof administered price adjustmentsmay have been the euro cash change-over. While the overall price effectsof the introduction of euro banknotesand coins remained limited, there wasevidence for some countries that themonths before and after the cashchangeover saw a high concentrationof adjustments of fees and charges.

In chart 7, the example of Ger-many illustrates the importance ofadministered prices for inflation de-velopments. Changes in administered

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prices are found to have a significantimpact on overall CPI inflation, partlydue to their high weight of nearly 20%in the CPI basket. Adjustments of ad-ministered prices played an especiallyimportant role in the run-up toEMU and during the year 2001 whenthese items saw inflation rates of 4%to 6% and thereby exceeded headlineinflation considerably.

In general, however, it can be as-sumed that the relevance of some ofthe factors underlying changes in ad-ministered prices will vanish in thenear future. The run-up to EMU and

the cash changeover are past eventsthat should no longer play a significantrole. Once the major wave of liberal-ization of network industries is over,the importance of these price adjust-ments for inflation differentials mayalso disappear. Yet, regulated pricesare likely to continue to impact on in-flation for several reasons. First, sincesome sectors will remain in publichands for strategic or political rea-sons, prices in these sectors will notbe determined by market forces; sec-ond, despite possible privatizations, inareas such as water supply or the rail-

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ways, prices may continue to be set orat least be heavily influenced by publicregulatory bodies because perfectcompetition is hardly conceivable inthese industries.

In the acceding countries, admin-istered prices play an even more im-portant role, as they constitute a sig-nificant share of consumer price indi-ces with a weight varying from about10% to 25% in the national CPI. Ac-cording to the 2001 Regular Reportsof the European Commission, theshare of regulated prices in the CPIis as follows: 18% in the Czech Re-public, 15% in Estonia, 18.5% inHungary, 22% in Latvia, 20.5% inLithuania and 12.7% in Slovenia. Ac-cording to national central bank re-ports, the share of regulated pricesin the consumer price index is as highas 25.7% in Poland (2001) and 21.1%in Slovakia (2002).

In the acceding countries, admin-istered prices represent not only alarge chunk of CPI but their adjust-ments, usually related to domesticpolitics, may be massive, abrupt andsystematically higher than the CPI.The transposition of the national CPIand administered prices in chart 8illustrates this phenomenon for theCzech Republic, Estonia, Hungary,Slovakia and Slovenia.

The underlying factors of hugepast and possible future increases inadministered prices are threefold.First, administered prices were keptunchanged during the 1990s whenother prices were liberalized. There-fore, large changes in administeredprices merely mirror a late catch-upwith other, chiefly market service pri-ces. Second, a part of administeredprices is still below cost recovery,

which implies further room for futureincreases. Third, the majority of regu-lated sectors are capital intensive. Pri-ces below cost recovery, which do notallow for capital maintenance costs,go hand in hand with an ever increas-ing need for capital investments so asto improve quality and to close thegap to constantly improving EU stand-ards. Consequently, sooner or latercapital investments are to be takeninto account.

3.3.5 The Role of TaxesIt iswidely acknowledged that differen-ces in indirect taxes, such as VAT andexcise taxes, are likely to play a nonne-gligible role in differing price levelsacross euro area countries, as shownin chart 9. Finland and Ireland, thecountries with the highest price levels,have the highest standard VAT rates in2003, whereas the core countries haverates ranging from 19% to 21%.15

Finally, Greece, Portugal and Spain ap-ply below-average rates. The same ap-plies to the reduced rates: countrieswith lower price levels tend to havelower reduced VAT rates. In addition,Greece, Portugal and Spain apply theserates more frequently. Of the 12 euroarea countries, six, among themGreece, Italy and Spain make use ofso-called super-reduced rates, whichvary from 2.1% to 4.3%. Indeed, theprice level and the VAT system appearto be linked in the euro area.

In contrast, low price level acced-ing countries have comparable or evenhigher standard and reduced VAT ratesthan countries in the euro area. Forinstance, Hungary and Slovakia havea standard rate of 25% and 23%, re-spectively, and it is 22% in the CzechRepublic and Poland. Hence, the

15 It is worth recalling that EU Member States can apply the following four types of VATrates: standard, reduced,super-reduced and zero rates. This can be completed by exemptions to VAT.




overall burden of indirect taxes is pre-sumably higher in the acceding coun-tries when compared with the euroarea. Therefore, the huge gap in pricelevels between the euro area and theCEE acceding countries is apparentlynot a result of differing VAT rates.

Given the relevance of indirecttaxes for euro area price level differ-ences the question to be addressedsubsequently is the extent to whichchanges in VAT rates may have con-tributed to price level convergenceor divergence over the last decade. Itturns out that VAT rates increasedslightly in Italy, Spain and Portugal.So did they in the case of Germanyand the Netherlands whereas theystayed unchanged in the remainingcountries except for Ireland, wherethe standard rate decreased some-what. The European Commission iscurrently seeking to simplify VAT reg-ulations by limiting the use of zero andsuper-reduced rates. Another objec-tive is that reduced rates should beused more homogeneously through-out the EU. If these amendments tothe sixth VAT Directive will be ap-plied, prices in countries using exten-sively super-reduced rates may in-

crease and they may decrease in coun-tries introducing reduced rates (Euro-pean Commission, 2003). This step islikely to contribute to dampening theimpact of taxes on price levels.

When it comes to the accedingcountries it should be noted that inthe framework of their Pre-AccessionEconomic Programs (PEP), countriesapplying reduced rates, i.e. the CzechRepublic, Hungary and Poland, com-mitted themselves to shift a limitednumber of items, mainly services,from reduced rates to standard rates.In addition, the Hungarian govern-ment decided to increase the reducedVAT rates from 0% and 12% witheffect from January 1, 2004, to 5%and 15%, respectively, in an attemptto consolidate public finances. Sincestandard rates will apply for a numberof items for which currently only re-duced or null rates are used, the Hun-garian central bank (Magyar NemzetiBank) expects the year-on-year infla-tion rate to increase to 5.8% by end-2004. Also, Slovakia recently intro-duced a flat rate of 19% that is appliednot only to VAT but also to incomeand corporate taxes.

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4 ConclusionsSince the beginning of the 1990s, themagnitude of inflation differentialshas decreased significantly, not onlyfor the EU-12 or the EU-15 but alsofor the EU-15+10. This reflects aconvergence of inflation rates in theEU and an overall disinflationary proc-ess in the acceding countries, which ischiefly driven by a stability-orientedmacroeconomic policy. The oftencited catching-up factors, whichwould work in the opposite direction,seem to be weaker than generallythought. But despite a dramatic con-vergence of inflation rates, inflationdifferentials did not vanish completelyin the EU-12. They became a sensitiveissue recently because sometimes theyare wrongly taken as a backward-look-ing benchmark for the success of amonetary union.

There are a number of potentialcauses of inflation differentials. Theyrange from cyclical factors via the ex-change rate pass-through and oil priceshocks to differences in productivityadvances and changes in indirecttaxes. An overview of these factorsand of their impact on differentgroups of EU countries reveals similarpatterns across countries. For in-stance, a similar degree of opennessis expected to result in a quite similarexchange rate pass-through, and thesame applies to oil dependency andoil intensity, factors which are key tothe pass-through of an oil price shock.

Therefore, economies with ahigher degree of openness, such asBelgium, the Netherlands and all theacceding countries (except for Po-land), are expected to be more sensi-tive to changes in the exchange rate.Similarly, economies that are more de-pendent on oil imports or rely onmore oil intensive industries are moreexposed to oil price shocks. The ac-

ceding countries appear to be verysimilar to the Mediterranean coun-tries in this respect.

Also, the acceding countries areoften found close to the EU Mediter-ranean countries with regard to pricelevels. Although the price level of du-rable goods in these countries isroughly in line with prices in the euroarea, service prices turn out to be halfas high as in the euro area or evenlower. However, recent calculationsfor the BS effect demonstrate thateven though service price inflationmight be driven by productivity gains,its impact on overall price inflation israther small and that the size of theBS effect in the acceding countries iscomparable to that found in the euroarea.

In addition to this, whereas regu-lated and administered prices are adistinct feature of inflation determina-tion in the acceding countries, one canalso find surprisingly high shares ofthis kind of prices in EU-15 countries,fairly often misused to consolidatepublic households. Different indirecttax rates, especially concerning theVAT, are another factor determiningprice levels. VAT rates may still differacross countries, but there are ongo-ing efforts to harmonize the tax ratesin the EU. Also, VAT rates in the ac-ceding countries are well in line withthose in the EU-12.

All said, it should be noted thatthe causes and extent of inflation dif-ferentials in the acceding countriesdo not differ fundamentally fromthose in the current EU MemberStates. Economic analysis of this phe-nomenon can hence rely on existingexplanatory approaches and experi-ence made in the industrialized coun-tries so far.

However, the acceding countries�medium-term objective of introducing




the euro will bring the topic ofinflation differentials back into focus.After all, the convergence criterionon price stability embodied in theMaastricht Treaty also relates to infla-tion differentials, establishing the ref-erence value on the basis of the averageof the three countries with the lowestinflation rates. For the single monetarypolicy, inflation differentials in general

play a subordinate role, since in itsmonetary policy decisions the Euro-system primarily takes into accountthe inflation rate of the euro area as awhole. As in the past an appropriate in-terplay of fiscal and structural policies— the instrument for inflation targetingat the national level — best ensures asmooth adjustment process in thenew Member States.

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