Working Paper: CEPR ID: DP4583
Authors: Patrick Honohan; Philip R. Lane
Abstract: 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.
Keywords: EMU; exchange rates; inflation
JEL Codes: E31; E42; F41
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Strength of the US dollar (1999-2001) (F31) | Inflation rates in Ireland (E31) |
| Weakness of the US dollar (2002 onwards) (F31) | Halt in Irish inflation (E31) |
| Exchange rate depreciation (F31) | Lower inflation rates (E31) |
| Exchange rate movements (F31) | Inflation differentials (E31) |
| Output gap (E23) | Significance of exchange rate variable (F31) |