4/2010 Karsten Staehr. Income convergence and inflation in Central and Eastern Europe: Does the sun always rise in the east?

Working Papers of Eesti Pank. No. 4/2010

This paper investigates the process of price convergence in the 10 new EU countries from Central and Eastern Europe. The analyses are based on panel data from 1995 to 2008 of the common currency price relative to the EU15 average. The lagged income level exhibit little explanatory power towards relative inflation, while the lagged price level has some explanatory power. In the long term the relative income and price levels are closely correlated implying concurrent nominal and real convergence. Deviations from the long-term relation between price and income levels are gradually closed by changes in relative inflation and GDP growth, but the process of convergence appears to be rather slow. In the short term the capital inflows associated with current account deficits put substantial upward pressure on the relative price inflation, while the Balassa-Samuelson effect appears to be subdued.
JEL Code: E31, O57, P24
Key words: real convergence, nominal convergence, real exchange rate, inflation, transition economies

* This paper was prepared for the conference "Economies of Central and Eastern Europe: Convergence, Opportunities and Challenges", 14-16 June 2009, Tallinn, Estonia. The author would like to thank Juan Carlos Cuestas and other conference participants as well as colleagues from Eesti Pank for useful comments. The usual disclaimer applies.

Author's e-mail address: karsten.staehr [at] tseba.ttu.ee, karsten.staehr [at] eestipank.ee

The views expressed are those of the author and do not necessarily represent the official views of Eesti Pank.

Contents

1. Introduction
2. Relative prices and relative income levels
3. A look at price and income levels in the new EU countries
4. Income levels and real appreciation
5. Co-integration and convergence
6. Final comments
References
Appendix 1. Estimations using deviation variables

Income Convergence and Inflation in Central and Eastern Europe: Does the Sun Always Rise in the East?, Working Papers of Eesti Pank No 4/2010 (PDF*)

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