Inflation and Business Cycle Convergence in the Euro Area: Empirical Analysis Using an Unobserved Component Model

The literature on optimum currency areas states that large inflation differentials can undermine monetary union. In the euro area, inflation rates diverged after the creation of the single currency, but started to converge again from mid-2002. Against this background, we assess the convergence of inflation rates and business cycles and study the relationship between them. The analysis is made using an unobserved component model estimated with the Kalman filter. In general, from 1980 to 2008 inflation rates and business cycles became more aligned in the euro area, but inflation rates converged more quickly than business cycles. The output gap is found to be a better indicator of the business cycle than unit labour cost when studying convergence. By looking at the causality between the convergence of inflation and output gap, it is found that inflation divergence has a limited destabilising economic impact.