Inflation Transmission in the EMU: A Markov-Switching VECM Analysis

This paper analyzes the transmission of inflation across the five largest economies in the European Monetary Union, i.e. France, Germany, Italy, Netherlands and Spain. We use monthly CPI inflation rates for the period 1970-2006. Given the long observation period and the continuing economic integration of Europe’s economies, we first try to investigate, if there were changes in inflation dynamics in these countries using univariate Markov-switching models. To assess the inflation transmission mechanism, we first establish a long-run relationship between the five countries using cointegration methods. As implied by the results of the univariate models, we allow for changes in the adjustment coefficients of the cointegrating relationships and the short-run dynamics. Using a Markov-switching vector error correction model we find evidence for multiple regime switches during the early 1970s till the mid 1980s. Exactly during this period we find evidence for Germany being weakly exogenous, which highlights the dominance of German monetary policy at this time. Since the mid-1980s we find evidence for a stable transmission mechanism both in the long- and the short-run characterized by a low degree of inflation persistence