Catching-up and inflation differentials in a heterogeneous monetary union: Some implications for the euro area and new EU Member States

We propose an alternative explanation for the nature, sources and consequences of inflation rate differentials in a monetary union, such as the euro area. We build on the new neoclassical synthesis (NNS) framework, recently advanced by Goodfriend [Goodfriend, M. 2002. Monetary Policy in the New Neoclassical Synthesis: A Primer. Federal Reserve Bank of Richmond, Richmond, VA] and Goodfriend and King [Goodfriend, M., King, R., 2001. Case for price stability. NBER Working Paper 8423, Cambridge, MA]. Based on the NNS setup, we discuss the inflationary consequences of the catching-up process in a heterogeneous monetary union. In particular, we explore the interaction between catching-up and inflation differentials and offer an interpretation of the nature of this interaction. We demonstrate that divergent inflation rates between Member States do not necessarily have to be an equilibrium phenomenon, even if the original shock comes from the supply-side of the economy. Second, we show how such divergence of individual country's inflation rates may arise when countries differ in size and in trend productivity growth.