The Euro and Inflation Divergence in Europe

I n January 1999, eleven European countries abandoned their respective national currencies and monetary independence to adopt a common currency, the Euro.1 This event, in which several industrialized countries formed a currency union, stands out in modern monetary history by its uniqueness, and in due time, it will allow for a better understanding of the implications of different monetary arrangements among countries. Already, with four years of data available, we can begin to learn from Europe’s natural experiment. In a flexible exchange rate regime, the equilibrium adjustment in the relative price across countries associated with a given country-specific shock results both from movements in nominal prices and from movements in the relative price of the countries’ currencies, i.e., the nominal exchange rate. In a currency union, movements in the nominal exchange rate are, by definition, no longer possible, and equilibrium adjustments in the relative price across countries result only from movements in nominal prices.2 In addition, countries in a currency union can no longer use monetary policy in response to such a shock. The equilibrium adjustment of nominal prices associated with a given country-specific shock reflects, among other factors, not only the degree of asymmetry of the shock but also the degree of integration of the different regions (namely, the mobility of factors of production or the ability