Inflation convergence in Central and Eastern Europe vs. the Eurozone: Non‐linearities and long memory

AuthorKarl Taylor,Juan Carlos Cuestas,Luis A. Gil‐Alana
Date01 November 2016
DOIhttp://doi.org/10.1111/sjpe.12114
Publication Date01 November 2016
INFLATION CONVERGENCE IN
CENTRAL AND EASTERN EUROPE VS.
THE EUROZONE: NON-LINEARITIES
AND LONG MEMORY
Juan Carlos Cuestas*, Luis A. Gil-Alana** and Karl Taylor*
ABSTRACT
In this paper, we consider inflation rate differentials between seven Central and
Eastern European Countries (CEECs) and the Eurozone. We test for conver-
gence in the inflation rate differentials, incorporating non-linearities in the
autoregressive parameters, fractional integration with endogenous structural
changes, and also consider club convergence analysis for the CEECs over the
period 1997 to 2015 based on monthly data. Our empirical findings suggest that
the majority of countries experience non-linearities in the inflation rate differen-
tial; however, there is only evidence of a persistent difference in some countries.
Complementary to this analysis we apply the Phillips and Sul (2007) test for
club convergence and find that there is evidence that most of the CEECs
converge to a common steady state.
II
NTRODUCTION
In the wake of economic crises in some Eurozone countries in recent years,
the merits of other countries being expected to join in the common currency
is subject to renewed scrutiny. The focus of this paper is to test whether there
is inflation convergence of the new member states from central and eastern
Europe with the rest of the Economic and Monetary Union (EMU). We focus
predominantly on those countries which have yet to join the Eurozone, but
also include Latvia and Lithuania, given its recent adoption of the euro.
1
With this analysis we may be able to shed some light on the debate of
whether or not it is a good idea to encourage more member states to adopt
the common currency, in terms of the consequences of asymmetric shocks and
the loss of monetary control to accommodate to them, in the Central and
Eastern European Countries (CEECs). The issue of whether applying the
same monetary policy to an area where different countries have different
*University of Sheffield
**University of Navarra
1
Latvia and Lithuania’s adoption of the euro occurred outside the sample period we focus
upon, see section ‘The data’.
Scottish Journal of Political Economy, DOI: 10.1111/sjpe.12114, Vol. 63, No. 5, November 2016
©2016 Scottish Economic Society.
519
inflation rates may be detrimental for some economies is debatable. This
argument is backed up by a number of authors such as Brissimis and Skotida
(2008), who found that it is important that the European Central Bank (ECB)
takes into account national characteristics when deciding monetary policy.
This does not go against the common finding (see Lim and McNelis, 2007,
among many others) that monetary policy should focus on inflation targeting.
Given the commitment from the ECB for price stability and the current
target to control inflation,
2
losing monetary policy may be especially problem-
atic if the countries face so-called ‘asymmetric shocks’. That is, shocks
affecting different countries in a different manner, and hence, causing a prob-
lem of synchronization of income, inflation and unemployment rates, which
potentially will require different policy responses. This is particularly impor-
tant in a monetary union, since it implies losing the possibility of intervention
in the exchange rate market to depreciate the currency, or the option of
financing deficits by monetary expansions. Most of the CEECs which are
already member states still have to fulfil the Maastricht convergence criteria
so as to be able to join the euro area.
3
Although only the first criterion
focuses explicitly upon inflation control, the rest of the criteria have a direct
link with the evolution of inflation expectations and, hence, inflation rate. For
this reason, the focus of this paper is inflation convergence.
The sample of countries considered in this paper consists of CEECs which
are member states but not part of the euro area, i.e. Bulgaria, the Czech
Republic, Hungary, Poland and Romania. Latvia and Lithuania have also
been included in the analysis, which may serve for comparison purposes.
These countries are an interesting case study since, during the period analysed,
they have been preparing for euro adoption.
4
Most of these countries joined
the EU in 2004, with the exception of Bulgaria and Romania which joined in
2007, and none of them joined with an opt-out clause. This means that even-
tually they all need to fulfil the Maastricht criteria and, when that happens,
they are expected to adopt the single European currency.
In this paper, we analyse the hypothesis of inflation convergence between
these countries and the Eurozone. Assessing this hypothesis will allow us to
provide valuable insights into the appropriateness of a centralized monetary
policy, with no possibility of devaluations. The process of transition from
planned economies towards that of a free market has been intense during the
last 20 years, following a series of structural and political reforms. However,
whether this process has facilitated conditions favourable to economic conver-
gence is open to debate. Currently, it is unknown whether their inflation rates
have converged to the same cycle and level as that of the Eurozone. Hence,
we test for inflation convergence between each CEECs and the Eurozone by
means of analysing the existence of unit roots in the inflation differentials for
2
The primary objective of the ECB’s monetary policy is to maintain price stability. The
ECB aims at inflation rates of below, but close to, 2% over the medium term.
3
Details on the criteria can be found in http://epp.eurostat.ec.europa.eu/statistics_
explained/index.php/Glossary:Maastricht_criteria.
4
Latvia adopted the euro on 1 January 2014, whereas Lithuania did on 1 January 2015.
520 J. C. CUESTAS, L. A. GIL-ALANA AND K. TAYLOR
Scottish Journal of Political Economy
©2016 Scottish Economic Society

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