Consequences of the inflation differences in the euro area

More than seven years after the completion of the European Monetary Union (EMU), the member countries continue to exhibit unequal business cycles, as shown by the analysis of the corresponding non-monetary data. With the introduction of the European Monetary Union, nominal interest rate differences within the EMU are a thing of the past. Still, there continue to be not insignificant differences in inflation rates, which have both structural causes as well as business cycle components. Multiple rigidities in the EMU contribute to keeping inflation differences alive longer than in other monetary areas. They also make the non-monetary consequences of the business cycle components more pronounced in the euro area. For instance, a country with a persistently high inflation rate enjoys the advantage of lower real interest rates. These, in turn, contribute to making real investments, such as those in real estate, more attractive than in countries with higher real interest rates. This tends to result in a higher share of investment in macroeconomic production, the latter rising accordingly. But the higher inflation rate also leads to a relentless deterioration in competitiveness, as prices and wages rise faster than in competing countries. While real interest rates lead to a persistent difference in development, the real exchange rate leads to convergence between the countries taking part in a monetary union. In the end, the question is which of these two mechanisms is more dominant. The European Central Bank argues that in the medium term, competition will be the "decisive spur for adjustment". The analysis of the EMU member country non-monetary data does not, however, support this view. No convergence in business cycle evolution has been evident in the past few years.