Ination Di¤erentials in a Currency Union: A DSGE Perspective

Cross country studies of in‡ation di¤erentials, and in particular in the EMU, have focused on three main explanations: (i) the role of tradable and nontradable sector productivity growth di¤erentials and the BalassaSamuelson e¤ect, (ii) the role of the demand-side e¤ects, and (iii) heterogeneity of in‡ationary processes inside the EMU. To understand the role played by each feature in shaping in‡ation di¤erentials, this paper estimates a two country, two sector Dynamic Stochastic General Equilibrium (DSGE) model with nominal rigidities in a currency union using data for Spain and the euro area. The paper …nds that productivity shocks in both sectors are the most important source of in‡ation di¤erentials, explaining about 75 percent of its variability. Demand shocks explain a large fraction of output growth variability, but not variability in in‡ation di¤erentials. In addition, the estimated model …nds evidence that in‡ation dynamics are di¤erent in Spain and in the rest of the euro area. Finally, the Balassa-Samuelson e¤ect does not appear to be important during the EMU period. JEL Classi…cation: F41, F42, C51.