Inflation Targeting in Presence of Balassa-Samuelson-Type Productivity Shocks

Abstract:     
This paper develops a two-sector small open-economy dynamic stochastic model with permanent technology shocks and price rigidities that allows for simulation of the differential productivity growth (Balassa-Samuleson-type productivity improvement). In addition, the model incorporates quality improvement to replicate typical terms of trade dynamics in new EU members. The model is calibrated for a typical new EU member country to asses whether the Balassa-Samuelson effect poses a threat to fullfiling the inflation Maastricht criterion. In addition, optimal policy is derived for a benchmark parameterization of the model. The results show that productivity growth differential need not generate the inflationary effects that represent significant risks to fullfilling Maastricht criteria in the ERM II.

Number of Pages in PDF File: 30

Keywords: Balassa-Samuelson effect, inflation targeting, ERM II, EMU

JEL Classification: E52, E31, F02, F41

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