Euro and convergence criteria: A cointegration analysis of inflation convergence

Abstract

ABSTRACT The Maastricht Treaty in 1992 established four `convergence criteria`, which must be satisfied by the member states before they adopt the single currency. According to the criteria, the economic indicators of countries must converge to those of best performing countries quantitatively. But, this is not a sufficient condition to achieve and keep stability in a monetary union. The co- movement of the series in the long-run is also necessary. This dissertation examines inflation convergence between each member and candidate countries of the EL) and European average by a cointegration analysis. Because, inflation is a key variable for any eventual devaluation in Exchange Rate Mechanism; and the fixed exchange rate regime requires common inflation rates to prevent wide shifts in competitiveness. German inflation rate is used as a proxy variable for European average in the analysis. The sample period begins from March 1993 because the topic of this dissertation is derived from Maastricht Treaty and there is a crisis in 1992. The results may be useful to provide some insights for the future performance of the EMU and for countries' ability to follow its policies. This empirical study is important, because it is the first study that examines inflation convergence for all member and candidate countries of the EU by using cointegration framework. The empirical results show that the European countries are still in process of convergence in spite of the most have satisfied the convergence criteria. There is a partial convergence of fiscal and monetary policies among the member states. In the case of any possible economic crisis, the negative effects of the shock will be bigger and continues, and the elimination of them by using common policies will take much more time. On the other hand, the VIcandidate countries do not converge with the EU, except Lithuania, and need more economic progress to catch up the European average. Key Words: Euro, Convergence Criteria, European Monetary Union (EMU), Maastricht Treaty, inflation convergence, cointegration framework, error correction mechanism. Vll