DP4583 Exchange Rates and Inflation Under EMU: An Update

Author(s): Patrick Honohan, Philip R. Lane
Publication Date: August 2004
Keyword(s): EMU, exchange rates, inflation
JEL(s): E31, E42, F41
Programme Areas: International Macroeconomics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=4583

In our recent Economic Policy article (Honohan and Lane, 2003), we argued that the strength of the US dollar 1999-2001 had an important impact on inflation divergence within the EMU and in particular the surge in Ireland?s inflation to over 7%. This hypothesis has been subjected to a grueling out-of-sample test: would the dollar?s subsequent weakness contribute to inflation convergence and in particular to a fall in Irish inflation? Fortunately for us, the theory has passed the test with flying colours. Irish inflation stopped dead in its tracks: consumer prices were unchanged between May and November of 2003. Regression analysis on quarterly inflation data across EMU members 1999.1-2004.1 confirms the importance of the exchange rate channel, although pinning down the exact dynamic specification will require a further span of data.