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Date of Award

Spring 2013

Document Type

Restricted Thesis: Campus only access

Degree Name

Bachelor of Sci/Business Admin

Department

Business

Abstract

Despite the economic integration promised by the Euro, some Eurozone nations continue to experience diverging price levels. This paper reviews the related literature and presents a new and updated model of Eurozone inflation differentials. The fundamentals developed by the Honohan and Lane (2003) research are used as the basis for this empirical analysis. Their paper models inflation differentials against short-run cyclical factors (the nominal effective exchange rate [hereafter the NEER] and national output gap and fiscal balance differentials) and long-run structural factors (lagged differential price levels). The authors find that the nominal effective exchange rate and the lagged price level differentials are the primary inflation drivers but, in short-run, the output gap is also statistically significant.

This research amends their original framework by including three additional variables: lagged national income differentials, lagged national growth rate differentials, and lagged national inflation differentials (to address the issue of autocorrelation). A second specification is created as a check for robustness and, to eliminate the subsequent effects of the 2008 financial crisis, only includes data through 2007. Additionally, there are three provisions across each specification: (1) all variables included (2) only variables deemed relevant included and (3) originally modeled variables included (based on Honohan and Lane, 2003).

While the original findings of Honohan and Lane are essentially replicated, the model’s application to a longer data series yields drastic variations (especially post-crisis). Lagged national growth rates and the lags in national price level and inflation rate differentials are the strongest variables, testing significant across both specifications. The NEER and output gap, while pertinent in other literature, did not withstand this experiment’s robustness tests. The results for differential income are inconclusive.

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