Diverging Inflation in Eurozone Countries. Current challenges and future prospects of the monetary union

Seminar Paper, 2022

16 Pages, Grade: 1,00




Reasons for rising european prices levels

20.1 Percent: Inflation in Estonia

4.8 Percent: Inflation in France

Futher implications and future challenges for eurozones monetary policy making



An issue, thought to be buried in the late 1970s occurred back on the stage of modern monetary policy making. The ghost of inflation woke up, rising price levels are back and are currently endangering the strong post-pandemic economic recovery. In the last months, inflation in eurozone countries has reached levels unprecedented for decades. This raises new challenges for monetary policy makers, when it comes to carefully assessing monetary policies future path, facing a potential tradeoff between safeguarding the post pandemic economic recovery and ensuring that inflation does not surge further. When analyzing current inflation numbers in eurozone it is conspicuous to see, that two countries diverge significantly: France and Estonia.

This figure has been removed by GRIN for copyright reasons.

Graph 1: Monthly Inflation Rate May 2022 for France, Euro Area, EU and Estonia,

Data: IMF World Economic Outlook

Frances’s inflation of May 2022 was at 5.8 %, whereas Estonia’s price levels have risen 20.1 % compared to the previous year, almost four times as much as Frances’s price levels (see Lang, Blechev, 2022). But why is Inflation rising again? What are the fundamental reasons for such a significant divergence within Eurozone countries? Why does France seem to handle inflation so much better than Estonia?

This paper aims at answering the question why inflationary dynamics vary so much within the same currency union. What challenges does this impose on the common monetary policy makers at the European Central Bank in Frankfurt, Germany?

REasons for rising european prices Levels

Prior to the COVID-19 pandemic, inflation was not an issue of monetary policy. In fact, there were more concerns about inflation being too low following a huge drop in oil prices in spring 2020. Back in 2020, the ECB was even undershooting its price stability goal of symmetric inflation around 2 percent, as the HCPI only rose by 0.7 percent. However, the tables have turned and currently, price level developments are far different from what they have been 2 ½ years ago. When comparing current inflationary developments to the last decades, it can clearly be seen, that we have entered a new area of significantly rising price levels compared to the previous decades. Whereas price levels were considerably low prior to the COVID-19 pandemic, they seem to have picked up since late autumn of 2021. In May 2022, the euro area annual inflation rate reached 8.1 percent, an increase of 6.1 percent compared to May 2021 (see Lang, Blechev, 2022). It is currently expected to remain elevated and more persistent then expected:

“Headline HICP Inflation is expected to remain very high for most of 2022, averaging 6.8 %, before abating gradually from 2023 and converging to the ECB’s inflation target in the second half of 2024”. (ECB Economic Bulletin, 2022)

Currently the main drivers of inflation are energy commodities, which have risen 39.1 percent in May 2022, compared to May 2021, followed by unprocessed food, which has gone up by 9 percent (See Lang, Blechev, 2022). This highlights the significant importance of Ukraine and Russia in global food supply. Inflation rates on food have risen from basically 0 to 9 percent over the course of the last year, whereas those of energy commodities have gone up from 13.1 to 39.1 percent.

The current rising price levels are due to two main reasons. First, supply bottlenecks: after the reopening of the economy inflation was pushing up in the last months of 2021. After production was reduced due to the lockdown-induced decline in demand, there was a large reduction in global economic activity, postponing investments and production. Since the vaccination campaigns became such a success at the beginning, a resurging increase in recovering domestic demand resulting from the stronger-then-expected economic recovery met a decreased supply, driving up prices significantly. Further, there was a lockdown-induced shift of expenditure towards goods in European countries. After consumption expenditures reduced significantly in spring 2020, demand for goods has already reached pre lockdown levels by the beginning of June 2020 (see Lane, 2022). Bottleneck driven inflation in the Euro area has been visible since February 2021. Following ECBs Chief Economist Phillip Lane, 3 main types of bottlenecks were responsible for driving up Inflation prior to the Russian attack of Ukraine:

1. Bottlenecks on manufactured goods and commodities
2. Oil and Gasprice developments
3. bottlenecks in the labor market

When examining several sectors form manufacturing, to transportation and services it can be seen, that while these sectors suffered from severe supply-demand-surpluses in 2020, supply-demand-deficits overtook by the beginning of 2021 (see Lane, 2022) Following the expectations made back in February 2022, prior to the Russian attack, bottlenecks were expected to be persistent for at least another six months. Back in February 2022, inflation was assumed to only be transitory based on the assumption, that

“pandemic-induced frictions disappear, and supply and demand adjust in response to relative price movements” (Lane, 2022).

However, forecasters and policy makers completely underestimated the possibility of the Russian attack and the further frictions this catastrophic war in Ukraine would imply for European trade and its energy supply. Recently, the ongoing war in Ukraine and the renewed pandemic related restrictions in China have contributed to worsening supply bottlenecks again, as Chinas strict Zero-COVID-Policy keeps vital production key components from being shipped around the globe.

The Russian attack on Ukraine has led to increases in oil, natural gas and vital food prices, affecting the member states of the same monetary union differently. Following the Russian attack, intercontinental trade was disrupted, leading to shortages of vital resources and raw material whereas energy prices increased significantly (see Economic Bulletin, 2022). The rising food prices following the Russian invasion of Ukraine reflect the fundamental importance of Ukraine’s agricultural sector for worlds food supply. In 2019, Ukraine accounted for an astonishing 10 percent of global food supply (see Saul, 2022). As a consequence of the war, wheat exports from Ukraine have been reduced by 64 percent compared to 2019. Meanwhile, the price of wheat has risen by 74.69 percent over the course of the last year (see Business Insiders, 2022).

Further, the war puts pressure on the fiscal space of European economies, as additional fiscal spending was necessary to curb the rising costs of living for consumers, expand eastern European defense capacities and care for Ukrainian refugees. Because of this, the European Commission wants to extend the General Escape Clause of the Stability and Growth Pact, enabling sovereigns to run a higher government debt without fearing financial sanctions. Growth projections across all European member states have been cut significantly due to greater uncertainty following the war and the adverse impact of higher inflation on disposable income. The worse outlook for 2022 is related to

“worsening of the economic cycle, increased expected interest payments and additional discretionary government spending”. (European Economic Bulletin, 2022)

In response to this increased inflationary environment, global financial conditions have tightened, as the ECB announced to end its net asset purchase program (APP) by the end of July. Further, ECB officials announced, that they intend to raise key interest rates by 0.25 percentage points at their July monetary policy meeting (see ECB, 2022) with further expected increases in autumn as inflation is currently expected to remain above target for quite some time.

20.1 Percent: Inflation in Estonia

The Country currently located at the upper end of Eurozone countries inflation is Estonia, with a HCPI increase of 20.1 percent in May 2022. Inflation in Estonia has almost quadrupled, coming from 4.49 percent in 2021, as pictured in Graph 2:

This figure has been removed by GRIN for copyright reasons.

Graph 2: Yearly developments of Inflation in Estonia (Data: IMF)

Currently, Estonian energy price increases are among the highest in the eurozone. Average households’ electricity prices have increased by 50 % in the second half of 2021, prior to the War (see Hankewitz, 2022).. Estonian Energy production does depend to a high degree on fossil fuels such as coal. In 2021, 53 % of local Energy production was based on coal and another 7.15 % on natural gas (see IAE). Inflation in Estonia is currently not only driven by rising prices for energy commodities According to the Estonian National Bank, money to the value of 7 percent of Estonian GDP has been added to the Economy via EU funds and budget deficits which made Estonian Production close to its productive capacity (see Rääsk, 2022).

The increasing Estonian energy commodity price levels are not the only reason contributing to strongly rising overall price levels. Moreover, the need to spend more on defense as well as the additional spendings to host the refugees from the Ukraine war, boosts local demand and drives up prices even further.

Additional thoughts on the increased government spending come from Madis Müller, the governor of the Eesti Pank (Estonian National Bank). He announced that it was considered…

“…worrying, that the gap between the revenues and expenses in the Estonian state Budget has already become permanent. […] We are currently able […] to cover only 85 cents of each Euro spend by the Estonian state from our own revenues” (Rääsk, 2022)

especially in the current inflationary environment. Furthermore, it is vital, that government spending does not put further pressures on prices which raises the importance of well targeted programs. Permanently, widely distributed subsidies cannot be the problems solution, as they further boost demand and therefore lead to further increasing prices.

“It is not wise to use one foot to press the brakes of monetary policy while stepping on the accelerator at the same time with the other foot” (Rääsk, 2022)

were the Words of the Gouverneur of the Estonian national Bank. He attributed the higher inflationary dynamics of his home country partially to excess government spending, creating excess demand for scare resources and thereby increasing prices further, although Estonia’s debt-to-GDP-ratio is currently the lowest of the whole eurozone (see Morena-Cabanillas, 2022). Mr. Müller further states, that the Estonian government must make investments to allow for dealing with the fiscal challenges associated with the refugees coming from Ukraine. Estonia has currently received 40 047 refugees from Ukraine (see Vahtla, 2022).

There is no need for direct support of Estonians, as too weak demand is not the problem the Estonian economy is facing rather increased insecurities and supply chain disruptions as a consequence of the Russian Invasion of Ukraine (see Rääsk, 2022). Estonia’s Inflation is therefor so high, as the country has more significant trade links with Russia and is heavily dependent on fossil energy sources.


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Diverging Inflation in Eurozone Countries. Current challenges and future prospects of the monetary union
Vienna University of Economics and Business
Catalog Number
ISBN (Book)
diverging, inflation, eurozone, countries, current
Quote paper
Moritz Ritter (Author), 2022, Diverging Inflation in Eurozone Countries. Current challenges and future prospects of the monetary union, Munich, GRIN Verlag, https://www.grin.com/document/1278540


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