Inflation Differentials in a Currency Union : A DSGE Perspective

Cross country studies of inflation differentials, in particular in the EMU, have focused on three explanations: (i) the role of tradable and nontradable sector technology shocks and the Balassa-Samuelson effect, (ii) the role of the demand-side effects, and (iii) heterogeneity of inflationary processes inside the EMU. 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, to understand the role of each feature in shaping inflation differentials. The paper finds that tradable sector technology shocks are the most important source of inflation differentials, while nontradable sector technology shocks help explain nontradable inflation only, and demand shocks help explain a fraction of output growth, but not of inflation dispersion. In addition, the estimated model finds evidence against inflation dynamics being different in Spain and in the rest of the euro area