Price Level Convergence, Relative Prices, and Inflation in Europe

38 Pages Posted: 11 Apr 2001

See all articles by John H. Rogers

John H. Rogers

Board of Governors of the Federal Reserve System - Trade and Financial Studies Section

Date Written: March 2001

Abstract

If price levels are initially different across the euro area, convergence to a common level of prices would imply that inflation will be higher in countries where prices are initially low. Price level convergence thus provides a potential explanation for recent cross-country differences in European inflation, a worrisome development under the ECBs "one-size-fits-all" monetary policy. I present direct evidence on price level convergence in Europe, using a unique data set, and then investigate how much of the recent divergence of national inflation rates can be explained by price level convergence. I show that between 1990 and 1999 prices did become less dispersed in the euro area. Convergence is especially evident for traded goods, and more in the first half of the 1990s than the second half. By some measures, traded goods price dispersion across the euro area is now close to that across U.S. cities. Despite an on-going process of convergence, deviations from the law of one price are large. Finally, I find a statistically-significant and robust negative relationship between the 1999 price level and 2000 inflation rate in Europe, and that the contribution of price level convergence to explaining inflation differentials is often quite important economically. Still, factors other than price convergence explain most of the cross-country inflation differences.

Keywords: prices, economic integration, exchange rates, purchasing power parity, euro

JEL Classification: E31, F36, F41

Suggested Citation

Rogers, John H., Price Level Convergence, Relative Prices, and Inflation in Europe (March 2001). FRB International Finance Discussion Paper No. 699. Available at SSRN: https://ssrn.com/abstract=266505 or http://dx.doi.org/10.2139/ssrn.266505

John H. Rogers (Contact Author)

Board of Governors of the Federal Reserve System - Trade and Financial Studies Section ( email )

20th St. and Constitution Ave.
Washington, DC 20551
United States
202-452-2873 (Phone)
202-736-5638 (Fax)

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