In‡ation Di¤erentials in a Currency Union: A DSGE Perspective, La Caixa Working Paper No. 6

Cross country studies of ination 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 Balassa-Samuelson e¤ect, (ii) the role of the demand-side e¤ects, and (iii) heterogene-ity of inationary processes inside the EMU. To understand the role played by each feature in shaping ination 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 \u85nds that productivity shocks in both sectors are the most important source of ination di¤erentials, explaining about 75 percent of its variability. Demand shocks explain a large fraction of output growth variabil-ity, but not variability in ination di¤erentials. In addition, the estimated model nds evidence that ination 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