Inflation and business cycle convergence in the euro area: Empirical analysis using an unobserved component model

Abstract

The optimum currency area literature highlights that large inflation differentials can undermine a monetary union. In the euro area, inflation rates diverged after the creation of the single currency, and started to converge again after mid 2002. Another point suggested by the literature is that business cycles are an important determinant of inflation differences across countries. Against this background, we assess the convergence of inflation rates and business cycles in the euro area and study the relationship between them. The analysis is done using unobserved component model estimated with the Kalman filter. In general, from 1980 to 2008, inflation rates and business cycles have become more aligned in the euro area. It is found that output gap is better than unit labour costs as an indicator of business cycle when studying convergence. We also conclude that inflation rates have converged faster than output gaps. When looking at the causality between the convergence of these two variables, it is found that the destabilising impact of inflation divergence is limited.