DP2684 | European Inflation Dynamics

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We provide evidence on the fit of the New Phillips Curve (NPC) for the Euro area over the period 1970?1998, and use it as a tool to compare the characteristics of European inflation dynamics with those observed in the U.S. We also analyse the factors underlying inflation inertia by examining the cyclical behaviour of marginal costs, as well as that of its two main components, namely, labour productivity and real wages. Some of the findings can be summarized as follows: (a) the NPC fits Euro area data very well, possibly better than US data, (b) the degree of price stickiness implied by the estimates is substantial, but in line with survey evidence and US estimates, (c)\ inflation dynamics in the Euro area appear to have a stronger forward-looking component (i.e., less inertia) than in the US, (d) labour market frictions, as manifested in the behaviour of the wage markup, appear to have played a key role in shaping the behaviour of marginal costs and, consequenty, inflation in Europe.