Inflation dynamics in european core and periphery countries: Impacts of PPI pass through

This paper examines inflation dynamics across European economies with an eye towards understanding how effective monetary policy is economies with different market structures.  One of the key indicators of monetary and economic integration is inflation convergence - one of the three convergence criteria that must be met to gain entry to the eurozone. The argument behind this criterion is that for a country to successfully bring its inflation rate in line with other, low inflation economies, it must adopt relatively strict monetary policy to temper inflation, thus ensuring relatively homogenous price behavior across member economies. However, in transition Eastern European countries, consumer goods and services markets are dominated by large monopolistic firms which reduces competition implying inflation is, to a greater degree than in Western developed economies, relatively susceptible to changes in producer prices and costs and less to demand shocks and monetary policy.  Moreover, labor market frictions and institutional inertia in small economies may further inhibit price convergence. We use an autoregressive distributed lag (ARDL) model to estimate the short and long run impacts of demand and cost side disturbances using quarterly data from 1989 – 2013. Our preliminary results suggest that in larger developed economies, which are characterized by a greater degree of retail competition, monetary policy will be more successful in controlling in inflation than in smaller periphery economies. These results demonstrate that for transition economies simply engaging in stricter monetary policy will be less effective than implementing reforms which promote competition if they are to meet the eurozone's convergence criteria.