Empirical Economics (2005) 30:137–150

DOI 10.1007/s00181-004-0227-3

Productivity growth and inflation in Europe:

Evidence from panel cointegration tests
Dimitris K. Christopoulos1, Efthymios G. Tsionas2
1
Department of Economic and Regional Development, Panteion University, 17671 Athens,
Greece (e-mail: christod@panteion.gr)
2
Department of Economics, Athens University of Economics and Business, Athens, Greece
(e-mail: tsionas@aueb.gr)

First version received: November 2001/Final version received: November 2003

Abstract. In this paper we investigate the productivity growth – inflation

nexus in fifteen European countries over the period 1961–1999 using panel
unit root and panel cointegration tests. Emphasis is placed on the distinction
between long-run and short-run causality using recently developed tests
appropriate for heterogeneous panel. The empirical results are relevant for
the role of the EMU and the Treaty of Maastricht in catching up, real con-
vergence, and the future growth prospects of Europe. The policy implications
of the findings are discussed in detail.

Key words: Productivity, inflation, panel unit roots, panel cointegration,

European Monetary Union, convergence

JEL classification: C22, C23, O40, E30

1. Introduction

The relation between inflation and productivity growth has been one of the
most widely investigated in the past fifteen years. Growing concern with
inflationary pressures has lead to the notion that fiscal and monetary disci-
pline will set the necessary conditions for stabilization, and long run growth.
The most important realization of this idea in economic policy has been the
European Monetary Union (EMU) and the Treaty of Maastricht. According
to the policy making prescriptions of the European Central Bank (ECB) the

The authors wish to thank two anonymous referees for helpful comments and suggestions on an
earlier version of the paper. Thank are also due to Peter Pedroni for providing his computer
codes.
138 D. K. Christopoulos, E. G. Tsionas

absolute priority is to keep inflation at a minimum (below 2%) and achieve

fiscal and monetary stability in the EU, accompanied by real convergence in
the south (Greece, Spain, Portugal, and Ireland). The budget deficit and debt
targets of the Treaty of Maastricht were set mainly in order to avoid infla-
tionary pressures, and the need to increase interest rates. This reveals that the
EMU has been considered a necessary condition for long run growth.
This is a testable proposition. If monetary and fiscal stability are a nec-
essary condition for growth, it must be the case that inflation and produc-
tivity growth are negatively related, in the short run, in the long run, or both.
In this context Jaret and Selody (1982, pp. 361) report that increases in
inflation have a negative impact on productivity growth as inflation ‘‘induces
an increasingly severe tax burden on the private sector because of a non neutral
tax structure’’
A number of paper have been concerned with the empirical relationship
between inflation and productivity in different countries (see Buck and
Fitzroy 1988; Selody 1990; Cozier and Selody 1992; De Gregorio 1992;
Sbordone and Kuttner 1994; Smyth 1995; Cameron et al. 1996; Gylfason
1997; Freeman and Yerger 1998; Hondroyiannis and Papapetrou 1998).
However, the empirical findings usually give contradictory results. Thus,
Buck and Fitzroy (1988), Cozier and Selody (1992), De Gregorio (1992),
Gylfason (1997), and Smyth (1995) find statistical evidence supporting the
negative relationship between inflation and productivity while Sbordone and
Kuttner (1994), Cameron et al. (1996), Freeman and Yerger (1997) and
Hondroyiannis and Papapetrou (1998) do not.
According to Sbordone and Kuttner (1994), Freeman and Yerger (1997)
and Hondroyiannis and Papapetrou (1998) the correlation between inflation
and productivity is ‘‘spurious’’ and due to cyclical movements of the two
variables. Tsionas (2000) investigated the inflation-productivity nexus for
fifteen European countries over the period 1960–1997 departing in several
ways from previous empirical work in the area. His empirical results imply
two-way causality between inflation and productivity for Belgium, Greece,
France, the U.K and Germany and one-way causality for Ireland and Fin-
land. For other countries, the study failed to document causality.
There are a number of concerns with previous empirical work. Although
the nature of I(1) variables has been recognized as critical, and proper esti-
mation techniques (organized around unit roots and cointegration) have been
used, the small samples typically used may significantly distort the power of
standard tests, and lead to misguided conclusions. The present paper ad-
dresses the empirical relationship between inflation and productivity for fif-
teen European countries namely, Belgium, Denmark, Germany, Greece,
Spain, France, Ireland, Italy, Netherlands, Portugal, the UK, Austria, Nor-
way, Sweden and Finland over the period 1961–1999. The paper uses panel
unit root and panel cointegration tests to avoid power distortions in small
samples. We distinguish between long run and short run causality, and argue
that the distinction has an important economic interpretation. The long run
relation between inflation and productivity growth is estimated using fully
modified OLS. Subsequently, error correction models are estimated, and
inferences about short run causality are drawn.
The remainder of the paper is organized as follows. Section 2 discusses the
econometric techniques. Section 3 discusses the empirical results. The final
section concludes the paper and provides some policy implications.
Productivity growth and inflation in Europe 139

2. Theoretical background and econometric techniques

The issue of the empirical association between inflation and productivity in

Europe is important from the policy viewpoint. In recent years there has been an
active discussion regarding the monetary unification at the EU level and its
implications for policy making in the EU. A prerequisite for a monetary union is
having similar fiscal and monetary backgrounds. For this reason, the Maas-
tricht Treaty required convergence in terms of rates of inflation, fiscal and
public debt indicators etc. Since the Maastricht Treaty is about nominal con-
vergence, one may argue that it is not enough for a successful monetary union
because different countries will still deviate in terms of productivity or structural
backgrounds and, therefore, asymmetric shocks will be a major problem for
policy making over the business cycle. If inflationary pressures over produc-
tivity growth are high, European economic policy will have to become more
restrictive which might lead to a downward revision of long-run growth pros-
pects. Taking into account the disequilibrium between the three leading cur-
rencies (US dollar, yen, and the euro) this could imply some additional strain
upon the EMU, which might have broader political implications for the EU as a
whole. Therefore, an investigation of the productivity growth – inflation nexus
is of paramount importance for policy making in the EU. To investigate this
issue, one must examine the empirical association between these two variables,
and document a statistically significant, structural, negative association and
also make a distinction between long-term and short-term effects.
There are a number of reasons why increased inflation may adversely
affect productivity growth. First, inflation may affect labor productivity by
causing an inefficient mix of factor inputs. Second, inflation reduces the
informational content of price signals, thus decreasing the ability of absolute
price measurements to reflect price changes accurately. With less information
upon which to base their decisions, business managers will make errors more
frequently, and will more often choose sub-optimal factor input mixes. Third,
increasing uncertainty about inflation can decrease productivity by inducing
firms to increase their inventories of unproductive buffer stocks and reduce
their expenditures on long-term basic research. Fourth, inflation erodes tax
reductions for depreciation and raises the rental price of capital which in turn
causes a reduction in capital accumulation and, therefore, in labor produc-
tivity. For more details, see Jaret and Selody (1982).
Let yit denote productivity growth in country i and year t (i ¼ 1; ::; n;
t ¼ 1; ::; T ), pit be the rate of inflation, sit the share of investment in GDP, and
qit the terms of trade.1 We use the following equations to investigate the
nature of the inflation – productivity growth nexus.
yit ¼ a0i þ a1i pit þ a2i sit þ a3i qit þ uit ð1Þ

pit ¼ b0i þ b1i yit þ b2i sit þ b3i qit þ vit ð2Þ

1
Productivity growth yit is measured as the annual percentage change in the ratio of real gross
domestic product over total employment. Terms of trade (qit) are computed as the ratio of import
price deflator to export deflator. Inflation rate (pit) is based on the CPI index. All data apart from
employment are expressed in US dollars, are drawn from the European Union’s AMECO
database (Annual Macro Economic Data Base DG2) and cover the period 1961–1999.
140 D. K. Christopoulos, E. G. Tsionas

We use two ancillary variables. The share of investment in GDP (sit ) and
terms of trade (qit ). Both variables are included in the above equations to
capture the effects of macroeconomic policy variables on productivity growth.
More specifically, it is expected that sit is positively correlated with produc-
tivity growth for obvious reasons. Terms of trade (qit ) is used as an ancillary
variable because Fisher (1993) found that increases in terms of trade are
associated with improvements in productivity growth. In other words, we
expect, ceteris paribus, a positive relationship between productivity growth
and terms of trade. On the other hand Bruno and Easterly (1998) using a
sample of 31 less developed countries over the period 1960–1994 find that
terms of trade have a negative impact on inflation rate. Of course, it remains
to be seen whether (1) and (2) represent structural relations and this will, in
fact, be the subject of much of our empirical analysis.
The first step in the empirical analysis is to investigate the stochastic
properties of the time series involved. More specifically, we perform unit root
tests on a per country basis. However, the power of individual unit root tests
can be distorted when the sample size (more accurately, the span of the data)
is small. For this reason, we need to combine information across countries,
and use panel unit root tests. The next step is to determine whether the
relationships are spurious or structural, using Johansen cointegration tests.
However, the power of the Johansen test in multivariate systems with small
sample sizes can be severely distorted. For this reason, we need to combine
information once again so we perform panel cointegration tests. Finally, gi-
ven that our relations are structural, we proceed to estimation using fully
modified OLS.

3. Empirical results

To tests for stationarity of the individual time series, augmented Dickey –

Fuller (ADF) unit root tests are carried out. The results in Table 1, imply that
all series exhibit non-stationarity in levels but not in their first differences at
conventional levels of statistical significance. This suggests that these series
are integrated of order one i.e., I (1). Exceptions are the productivity series for
Spain, Norway, and Finland, investment share for Sweden, and terms of
trade for Spain. However, we do not view this as a problem, because the
power of ADF tests depends to a large extent on available number of time
observations, T ¼ 39.
Panel unit root tests, on the other hand, are expected to be much more
powerful since they combine information from time series as well as cross-
sectional data. The Im, Pesaran and Shin (IPS) (1997) and Maddala and Wu
(henceforth MW) (1999) tests are conducted to check for the presence of a
unit root for all variables in both levels and first differences in the context of
panel data. In both tests, the null hypothesis is that of a unit root. The IPS
and MW tests are presented in the Appendix. The MW test has the advantage
over the IPS that its value does not depend on different lag lengths in the
individual ADF regressions. In addition Maddala and Wu (1999) found that
the MW test is superior compared to the IPS test. Baltagi and Kao (2000, p.9)
report that Fisher type tests such as MW are superior to the IPS in terms of
size-adjusted power. The results of the tests are provided in Table 2. The
conclusion is that all series are I(1) with the exception of productivity for
Productivity growth and inflation in Europe 141

Table 1. ADF unit root tests

Productivity (y) Inflation (p) Investment share (s) Terms of trade (q)

Country Levels Diff Levels Diff Levels Diff Levels Diff

Belgium )1.62 )4.49*** )2.71 )3.97*** )2.04 )3.22** )1.91 )2.76*
Denmark )3.12 )5.57*** )1.65 )3.29* )2.00 )2.95** )1.49 )3.74***
Germany )2.94 )4.84*** )2.98 )3.59** )2.39 )1.06 )2.29 )3.28**
Greece )2.13 )3.95** )0.73 )4.36*** )1.31 )2.23 )0.82 )4.22***
Spain )3.72*** )4.30*** )1.93 )2.45 )2.39 )3.11** )3.22*** )3.56**
France )2.16 )3.73** )1.75 )3.65** )2.69 )2.67* )1.42 )3.11**
Ireland )2.78 )5.02*** )1.24 )3.66** )1.98 )3.05** )2.34 )3.76***
Italy )2.75 )4.16*** )1.21 )3.35** )3.38 )4.03** )1.43 )2.98**
Nether- )2.79 )4.03*** )2.55 )3.57** )1.83 )2.69* )2.67 )3.35**
lands
Portugal )2.75 )6.15*** )1.21 )5.32*** )2.15 )4.57*** )1.45 )2.42
UK )3.62 )5.85*** )2.00 )3.89*** )2.14 )2.83* )2.55 )3.26**
Austria )1.51 )3.38* )2.48 )3.51** )2.09 )3.41** )1.52 )3.86***
Norway )3.57*** )6.05*** )1.89 )5.18*** )2.23 )3.54*** )2.42 )3.48**
Sweden )2.79 )5.43*** )1.51 )3.71** )3.47** )3.22** )1.47 )3.02**
Finland )3.53*** )5.23*** )2.23 )3.47** )2.72 )2.99** )2.51 )3.51***

Diff denotes the augmented Dickey-Fuller t-tests for a unit root in the first differences model.
Number of lags was selected using the AIC criterion. Boldface values denote sampling evidence in
favour of unit roots.
(***), (**), (***) Signify rejection of the unit root hypothesis at the 1%, 5% and 10% level
respectively.

Table 2. Panel unit root tests

Levels First differences

Variables IPS MW IPS MW

y )2.70*** 49.77 )12.31*** 184.72***
p 1.36 17.44 )7.57*** 114.34***
s )0.65 31.20 )7.06*** 104.89***
q 0.91 21.56 )7.61*** 122.68***

Notes: IPS and MW are the Im, Pesaran and Shin and Maddala and Wu t-tests for a unit root in
the model. The critical values for MW test are 50.892 and 43.77 at 1% and 5% statistical level
respectively Boldface values denote sampling evidence in favour of unit roots.
***
Signifies rejection of the unit root hypothesis at the 1% level.

which the IPS statistic rejects the presence of a unit root even at 1% level of
significance. However, the MW test offers evidence that this variable contains
a unit root. Given the fact that the MW appears to be more powerful than the
IPS, we can conclude that none of the variables is stationary in levels. Both
tests are also performed using first differences. It turns out that all series are
stationary in first differences. Therefore, it is reasonable to claim I(1) as a
reasonable representation of this data.
Next, we proceed to test for cointegration using the maximum likelihood
approach developed by Johansen (1988). See also Johansen and Juselius
(1991). From the results in Table 3, the null hypothesis of no co-integration
(r ¼ 0) can be decisively rejected at conventional levels of statistical signifi-
cance for all sampled countries. The null hypothesis of one cointegrating
vector (r
1 given that r
0 was rejected) cannot be rejected. Therefore, we
142 D. K. Christopoulos, E. G. Tsionas

have strong evidence in favor of the hypothesis of one cointegrating vector. In

other words for all countries we examine a unique cointegrating vector seems
to be a reasonable hypothesis.
However, since the power of individual Johansen cointegration tests can be
distorted when the span of the data is short as in our case (T=39) additional
panel cointegration tests are conducted to make sure that problems of power
in finite samples do not distort the conclusions derived from Johansen’s tests.
Thus, we use a panel cointegration statistic suggested by Pedroni (1997,1999).
This test is an ADF test applied to generated residuals from (supposedly) long
run relations. A detailed description of this test is presented in the Appendix.
The results are reported in Table 4 and indicate, under the assumption of
alternative dependent variables, that the only way in which we cannot reject
panel cointegration is when productivity (y) is the dependent variable. Having
p; s or q as dependent variable, shows absence of cointegration so such
relations are spurious. Other things being equal, a single cointegrating vector
exists among y and p; s or q. However, since Pedroni ADF statistic is residual-
based, we also use Fisher’s test to aggregate the p-values of individual
Johansen maximum likelihood cointegration test statistics. If pi denotes the
p-value of the Johansen statistic for the i th unit, then we have the result
PN
2 log pi  v22N . This test is distributed as v2 with degrees of freedom twice
i¼1
the number of cross-section units, i.e. 2N , under the null hypothesis. The
results presented in Table 4 give additional support to the view that a single
cointegrating vector exists. Therefore, we conclude that both residual as well as
maximum likelihood tests confirm the existence of a unique cointegration vector.

Table 3. Johansen cointegration tests

Max eigenvalue statistics for H0: rank = r

r ¼ 0 (70.05, 62.99) r
1 (48.45, 42.44) k

Country
Belgium 69.99b 34.81a 1
Denmark 71.93a 36.35a 1
Germany 75.00a 36.41a 1
Greece 77.14a 40.89a 3
Spain 69.43b 29.26a 1
France 72.43a 40.68a 1
Ireland 91.49a 29.06a 2
Italy 77.09a 41.76a 2
Netherlands 83.23a 43.75a 2
Portugal 88.44a 39.86a 1
UK 69.64b 37.15a 1
Austria 95.82a 26.31a 4
Norway 68.20b 22.86a 2
Sweden 75.44a 39.73a 1
Finland 63.40b 36.69a 3

r: Number of cointegrating vectors. The optimal lag structure (k) for the VAR was selected by
minimizing the AIC criterion.
a
and b Indicate rejection of the null hypothesis at 5% and 1% level respectively.
Numbers in parentheses next to r ¼ 0 and r
1 represent the 1% (first number) and 5% (second
number) critical values of the test statistic.
Productivity growth and inflation in Europe 143

Table 4. Panel cointegration tests

Dependent variable Pedroni Fisher v2 cointegration test

y )14.68*** r=0 r£1

129.97 29.31
p )1.28
s )0.85
q )2.11

Notes: Boldface values denote sampling evidence against cointegration.

***
Signifies rejection of the null hypothesis of no-cointegration at 1% significance level. The
critical values for Fisher v2 cointegration test test are 50.892 and 43.77 at 1% and 5% statistical
level respectively

Table 5. Long-run panel causality tests

H0: No causality v2 p-values

p to y ðki1 Þ 385.19 0.001

y to p ðki2 Þ 13.20 0.59

Next, to examine the direction of long run causality between productivity

and inflation in a panel data context we adopt a procedure suggested by
Canning and Pedroni (1999)2. See also Jones and Joulfaian (1991). This
procedure consists in estimating an error correction model (ECM) of the
following type:
X
mi X
mi
DZit ¼ ai þ bij DZitj þ Dx0 itj cij þ ki ðZit1  x0 it di Þ þ eit ð3Þ
j¼1 j¼1

whereZ is the set of I(1) stochastic variables that is y, p; s and q,

xit ¼ ½yit ; ptt ; stt ; qtt  represents the vector of productivity, inflation, investment
share, and terms of0 trade, cij is a 3  1 vector of short run parameters,
ki ¼ ðki1 ; ki2 ; ki3 ; ki4 Þ is a vector with the same dimensionality as the number
of variables in the system, ½1; di  is the cointegrating vector of country i and
mi denotes the number of lags for country i.
To test for the existence of a long-run effect running from inflation
(productivity) to productivity (inflation) the following hypothesis are for-
mulated:
p to y H0 : ki1 ¼ 0 8i:
H0 : ki1 6¼ 0 for at least one i.

y to p H0 : ki2 ¼ 0 8i:
H0 : ki2 6¼ 0 for at least one i.
As reported in Table 5 the null hypothesis of no long-run effect of y on p is
rejected at 1% level of significance while the null hypothesis of long-run effect
of p on y cannot be rejected at 1% level of statistical significance. These

2
An anonymous referee proposed this analysis to us.
144 D. K. Christopoulos, E. G. Tsionas

findings show the presence of a long-run causality relationship going from

inflation (p) to productivity (y).
Having established cointegration as well as the direction of causality in the
long run, we proceed to estimation of the long run structural specification by
the method of fully modified OLS. This methodology addresses the problem
of non-stationary regressors, as well as, the problem of simultaneity biases. It
is well known that OLS estimation yields biased results because, in general,
the regressors are endogenously determined in the I(1) case.
Consider the following cointegrated system for panel data
yit ¼ ai þ x0it b þ uit ð4Þ

xit ¼ xi;t1 þ eit ð5Þ

0
where nit ¼ ½uit ; e0it 
is stationary with covariance matrix Xi . Following Phil-
lips and Hansen (1990) a semi-parametric correction can be made to the OLS
estimator that eliminates the second order bias caused by the fact that the
regressors are endogenous. Pedroni (2000) follows the same principle in the
panel data context, and allows for heterogeneity in the short run dynamics as
well as in fixed effects.
The estimation results are reported in Table 6. The results confirm the
notion that investment shares represent an important determinant of growth
(this variable is highly significant in the panel, with a t-statistic of 8.62).
Terms of trade are also significant (with t-statistic 2.11) and the expected
negative sign. Inflation is found to be highly significant (t-statistic is 7.29) and
exerts a negative effect on productivity.
These results confirm the existence of negative effects of inflation on
aggregate productivity, and the need to control inflation by restrictive mon-
etary and fiscal policy (along the lines of the EMU) in order to stabilize
European economies, and create the necessary conditions for future
improvements in productivity and growth.3
The negative effect of inflation on productivity is confirmed at the country
level, and are given by heterogeneous panel fully modified OLS estimates
reported in the same table. There are a few exceptions though. Inflation has a
statistically significant coefficient for Germany, Greece, Italy, Austria, Nor-
way, Sweden, and Finland. It also has positive sign for the Netherlands, and
Portugal, but the respective coefficients are not statistically significant. In
these cases, we cannot establish inflation – productivity nexus.
Part of the problem could be the presence of the terms of trade variable,
which reflects devaluation effects at least for the southern European countries
of Greece, Spain and Portugal. For these countries, although we cannot
establish a nexus, it is probable that the effect of inflation passes through the
devaluation effect, which is reflected on q.
Further investigation of this issue would require a full econometric model
for each country, and this is outside the main scope of this analysis. However,
what emerges as conclusion, is that in about half the countries in the sample, we
can establish a long run cointegrating equation between inflation and produc-

3
An anonymous referee pointed out to us that these results are true only when the impact of
(restrictive) monetary and fiscal policy is neutral in the long run on productivity and growth, and
an issue might arise if they affect productivity and growth in the perverse way.
Productivity growth and inflation in Europe 145

Table 6. Fully modified OLS estimates

Country p s q

Belgium )0.09 0.57*** 0.11

[1.09] [4.50] [1.32]
Denmark )0.11 0.005 )0.11
[1.10] [0.01] [0.89]
Germany )0.32** 0.31*** )0.07**
[2.70] [6.33] [2.22]
Greece )0.32*** 0.31*** 0.14
[3.77] [4.40] [1.32]
Spain )0.09 0.54*** 0.14***
[1.22] [3.71] [4.84]
France )0.05 0.25* )0.03
[0.38] [1.64] [0.54]
Ireland )0.07 0.04 0.01
[0.70] [0.28] [0.13]
Italy )0.46*** 0.47*** 0.14***
[3.91] [6.75] [2.53]
Netherlands 0.04 )0.01 )0.45***
[0.53] [0.16] [3.28]
Portugal 0.10 0.21 )0.20**
[1.06] [1.04] [2.58]
UK )0.08 0.15 )0.01
[1.01] [1.30] [0.12]
Austria )0.27** )0.05 )0.30***
[2.48] [0.30] [6.25]
Norway )0.29*** 0.01 )0.06***
[3.28] [0.17] [2.24]
)0.34*** 0.11 )0.03
Sweden [4.52] [0.95] [0.44]
Finland )0.34*** 0.19** 0.02
[3.66] [2.76] [0.24]
)0.18*** 0.21*** )0.05**
Panel [7.29] [8.62] [2.11]

Notes: Figures in brackets are absolute t-ratios.

***, **
Indicate statistical significance at the 1% and 5% level respectively.

tivity (with terms of trade and investment share present in the long run
relation). The existence of a nexus is confirmed for these countries, as well as
the panel as a whole.
Next, we investigate short run causality by means of error correction
models (ECM) (3). In this type of models the lagged coefficients on X that is
cij;1 ¼ 0; j ¼ 1; 2; ::; mi for each specific country can be used to test for
Granger short–run causality in the panel context. Tests of the hypothesis that
coefficients cij;1 ¼ 0; j ¼ 1; 2; ::; mi must be jointly zero in every country if
inflation (productivity) has no short run effect on productivity growth
(inflation) are standard v2 ðmi Þ Wald tests. Clearly, although a long run effect
may be absent, we may still have a short run effect. The meaning of such
finding would be that inflation does not affect the equilibrium level of pro-
ductivity but only the transition path towards its long run equilibrium.
In this case the short run effects are as significant as long run effects. Even
if there is no inflation – productivity nexus, but inflation does affect the
transition path, different fiscal and monetary policy arrangements would
146 D. K. Christopoulos, E. G. Tsionas

affect the short run state of the economy, so some policies would have to be
better than others in terms of transition dynamics. Selecting such policies, and
even realizing the fact that certain policies are different than others in
the transition sense, is important for the sustainability of the EMU and the
politics within the EU. For the southern part of Europe, for example, the
critical issue is catching up with the average of EU in terms of real per capita
GDP (one of the goals of the Integrated Mediterranean Programs in the past,
and the Support Frameworks more recently). This implies that productivity
growth rates must not only increase in the long run, but must also increase at
a sufficiently high rate in the short run, ideally following a transition path of
steady increase. This is one example where the short run inflation - produc-
tivity nexus is important. The deeper reason is, of course, that if inflation does
affect productivity in the short run, implying a particular transition path for
productivity to its steady state, fiscal and monetary arrangements must be
accommodating for the ‘‘best’’ transition path. Surely, what constitutes
‘‘best’’ differs from country to country (otherwise the EMU would not have
been such a disappointing political experience) but the real question we want
to answer is the following. Given existing EMU arrangements and economic
policy configurations, is there still a negative effect from inflation on pro-
ductivity growth? In other words, does inflation convergence and monetary
stability as summarized by the Maastricht criteria imply productivity gains
for Europe, and the south in particular?
The empirical results are reported in Table 7. The first column of the table
provides p-values of Wald v2 tests of the significance of inflation lags in the
productivity growth ECM model. The second column provides p-values of
Wald v2 tests of the significance of productivity lags in the inflation ECM model.
The last column simply reports the t-statistics of k1i s for the equation of pro-
ductivity. The results indicate that for the panel as a whole we cannot reject the
joint hypothesis that inflation lags are zero. This is not true for the productivity
lags in the inflation equations. Therefore, we can conclude that short run cau-
sality tests confirm the hypothesis that inflation exerts a negative impact on
productivity growth while the reverse relationship cannot be documented. On a
per country basis the results are a bit disappointing to the idea of short run
causality. More specifically, in only five countries out of fifteen we can docu-
ment some effect. These countries are Denmark, Germany, France, Italy and
Portugal. For these countries the comments about short run causation between
productivity growth and inflation seem to apply: The EMU and nominal
convergence in terms of the Maastricht targets improved the performance of the
real economy in Denmark, Germany, France, Italy and Portugal, and accom-
modated real convergence. For other countries short run causality is rejected.
Finally, the hypothesis that productivity growth does not affect inflation cannot
be rejected for all countries we examine and in the panel as a whole. A possible
exception is the Netherlands. However, the p-value is relatively high 0.09

4. Concluding remarks

The relationship between productivity and inflation has been an issue of

concern in academic and policy-making circles for long time. This study
represents, as far we know, the first attempt to address the causal order
between productivity growth and inflation in fifteen European union
Productivity growth and inflation in Europe 147

Table 7. Short run causality tests between y and p: ECM models

Country Inflation Productivity Equilibrium error in the

lags p-values lags p-values equation of productivity
t-statistics

Belgium 0.90 0.27 )4.44***

Denmark 0.06 0.54 )4.36***
Germany 0.08 0.19 )4.13***
Greece 0.25 0.53 )3.10***
Spain 0.32 0.33 )4.16***
France 0.05 0.22 )2.14**
Ireland 0.50 0.90 )4.68***
Italy 0.005 0.30 )1.70*
Netherlands 0.79 0.09 )3.47***
Portugal 0.04 0.81 )3.93***
UK 0.44 0.17 )3.81***
Austria 0.75 0.43 )2.35***
Norway 0.22 0.57 )2.57***
Sweden 0.76 0.34 )4.26***
Finland 0.11 0.39 )3.23***
Panel 0.03 0.35
***, **, *
Notes: Indicate statistical significance at 1%, 5% and 10% level respectively.

countries on the basis of panel-based unit root and cointegration estimation

procedures. These techniques avoid power distortions of standard tests in
small samples and thus misguided conclusions. The fully modified OLS
technique that corrects the biases caused by the fact that the regressors are
endogenous, is used in the context of a heterogeneous panel to investigate the
long run relation between inflation and productivity growth. In addition, an
error correction model is employed to study the pattern of causality both in
the long-run and in the short-run.
Two points emerge from the empirical analysis. (i) In the long run there is
unidirectional causality from inflation to productivity growth. The estimates
support a negative equilibrium relationship between productivity growth and
inflation for the panel as a whole as well as for about half the countries
examined namely, Germany, Greece, Italy, Austria, Norway, Sweden and
Finland. For the remaining countries a statistically significant relationship
could not be established. The policy implication of this finding is that for
these countries (where a negative effect is documented and for the panel as a
whole) inflation can be considered as an additional channel through which
productivity growth could grow faster. Thus, convergence of European
inflation to 2% (from over 20% for some countries in the 1980s) is a strong
base to foster real economic convergence among EU members.
(ii) Evidence is found for short run causality between productivity
growth and inflation in five out of fifteen countries we examine and in the
panel as a whole. These countries are Denmark, Germany, France, Italy and
Portugal. Thus inflation seems to affect productivity growth during the
transition to the steady state. This implies that the disinflationary effects of
the EMU, work mainly in the long run. In this framework the introduction
of a common currency as a necessary condition to ensure long-term price
stability and sustainability of EMU, appears to be relevant for real con-
vergence in Europe.
148 D. K. Christopoulos, E. G. Tsionas

Appendix: Tests for panel unit roots and panel cointegration

The Im-Pesaran-Shin (IPS) test

The IPS statistic is based on averaging individual Dickey-Fuller unit root

tests (ti ) according to
pffiffiffiffi
N ðt  E½ti jqi ¼ 0Þ
tIPS ¼ pffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffi ! N ð0; 1Þ ðA1Þ
var½ti jqi ¼ 0
PN
where t ¼ N 1 ti . The moments of E½ti jqi ¼ 0 and var½ti jqi ¼ 0 are
i¼1
obtained by Monte Carlo simulation and are tabulated in IPS.

Maddala and Wu (MW) test

P
N
The MW statistic is given by P ¼ 2 ln pi , and combines the p-values from
i¼1
individual ADF tests. The P test is distributed as v2 with degrees of freedom
twice the number of cross section units, i.e. 2N , under the null hypothesis.

Pedroni’s test

Following Pedroni (1997) an appropriate panel cointegration test can be

conducted as follows: Consider the following model for heterogeneous panel
data
yit ¼ ai þ di t þ x0it bi þ eit ðA2Þ
 
yit
For the process zit ¼ it is assumed that it follows a multivariate random
xit ½Tr
P
walk zit ¼ zi;t1 þ nit , and that T 1=2 nit converges to a vector Brownian
t¼1
motion on the interval r 2 ½0; 1 with asymptotic covariance Xi . Let ^eit denote
the estimated residuals, X ^ i a consistent estimator of Xi , and let ^s2 and r^2 be
i i
the contemporaneous and long run variances of the residuals
^vit ¼ ^eit  q^i^ei;t1 . If we define the statistic
" #1=2
XN X T X
N X T
Zt ¼ r~ ‘2 ^ 2 2
X ^e ^ 2 ð^ei;t1 D^eit  k^i Þ
X ðA3Þ
NT NT 11i i;t1 11i
i¼1 t¼1 i¼1 t¼1

1
PN
^ r^ , k^i ¼ ð^
2
where r~2NT ¼ N X11i i
2 1 2
2 ri  ^s2i Þ, then Pedroni (1997, p.12) shows
that i¼1

1
pffiffiffi ðZ^tNT  lN 1=2 Þ ! N ð0; 1Þ ðA4Þ
v
where v and l are determined by the number of regressors.
This is a test for the null hypothesis of no cointegration.
Productivity growth and inflation in Europe 149

Fully modified OLS estimation of cointegrating vector for panel data

Consider the following cointegrated system for panel data

yit ¼ ai þ x0it b þ uit
xit ¼ xi;t1 þ eit
where nit ¼ ½uit ; e0it  is stationary with covariance matrix Xi . Pedroni’s esti-
mator is
!1 !
X
N X
T
2
X
N X
T
b^FM  b ¼ ^ 2
X 22i ðxit 
xt Þ  ^ 1 X
X ^ 1
11i 22i ðxit 
xt Þuit  T c^i
i¼1 t¼1 i¼1 t¼1
ðA5Þ
where
^ 1 X
uit ¼ uit  X ^ ^0  X
^ 21i þ X
^i ¼ C ^ 1 X
^ ^ ^0
^ 22i 21i ; c 21i 22i 21i ðC22i þ X22i Þ
where the covariance matrix can be decomposed as Xi ¼ X0i þ Ci þ Ci where
X0i is the contemporaneous covariance matrix, and Ci is a weighted sum of
^ 0 denotes an appropriate estimator of X0 .
autocovariances. Also, X i i

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