Highlights :

• This paper studies the contribution of real interest rate divergence to the dynamics of the relative price of non-tradables within Europe.
• It suggests an extension of the traditional Balassa-Samuelson framework to analyze the impact of the real interest rate on the dynamics of the relative price.
• It documents the expansion of the non-tradable sector in the periphery before the euro crisis.
• It carries out an econometric estimation for 11 EA countries over 1995-2013 and quantifies the contribution of the pure Balassa-Samuelson effect and the impact of the interest rate on non-tradable relative prices.
• In Greece, the fall in the real interest rate over 1995-2008 could explain almost half of the non-tradable price increase relative to the EA average, while in Germany the increase in the real interest rate might have contributed up to 7% of the decrease of the non-tradable price relative to the average of the EA.

 Abstract :
This paper studies the contribution of real interest rate divergence to the dynamics of the relative price of non-tradables within Europe. Based on a model by De Gregorio et al. (1994), it shows that the real interest rate fall in the Euro Area (EA) periphery following the single currency's inception induced an increase in the relative price of non-tradable goods. Using a new dataset, it documents the dynamics of the tradable and the non-tradable sectors over 1995-2013 and the expansion of the non-tradable sector in the periphery before the euro crisis. It then carries out an econometric estimation for 11 EA countries over 1995-2013 and quantifies the contribution of the pure Balassa-Samuelson effect and the impact of the interest rate on non-tradable relative prices. Diverging evolution in the interest rate impacted greatly the evolution of non-tradable relative prices within the euro area over the period. In Greece, the fall in the real interest rate over 1995-2008 could explain almost half of the non-tradable price increase relative to the EA average, while in Germany the increase in the real interest rate might have contributed up to 7% of the decrease of the non-tradable price relative to the average of the EA.

 Keywords : Non-tradable prices | Balassa-Samuelson effect | Real interest rate

 JEL : F41, F45, E43