Output Divergence in Fixed Exchange Rate Regimes: Is the Euro Area Growing Apart?

Tinbergen Institute Discussion Paper 2022-031/VI

63 Pages Posted: 5 May 2022

See all articles by Yao Chen

Yao Chen

Erasmus University Rotterdam (EUR) - Erasmus School of Economics (ESE)

Felix Ward

Erasmus University Rotterdam (EUR) - Erasmus School of Economics (ESE)

Date Written: April 2022

Abstract

Can fixed exchange rate regimes cause output divergence among member states? We show that such divergence is a long-run equilibrium characteristic of a two-region model with fixed exchange rates, heterogeneous labor markets, and endogenous growth. Under flexible exchange rates, monetary policy closes output gaps and realizes the associated maximum TFP growth in both regions. Upon fixing exchange rates, the region with higher structural wage inflation falls into a low-growth trap. When calibrated to the euro area, the model implies a slowdown in the TFP growth rate of the euro area’s periphery relative to its core. An empirical analysis confirms that the periphery’s higher structural wage inflation rate contributed to its lower TFP growth in the aftermath of joining the euro.

Keywords: exchange rate, growth, monetary policy

JEL Classification: E50, F31, O40

Suggested Citation

Chen, Yao and Ward, Felix, Output Divergence in Fixed Exchange Rate Regimes: Is the Euro Area Growing Apart? (April 2022). Tinbergen Institute Discussion Paper 2022-031/VI, Available at SSRN: https://ssrn.com/abstract=4098103 or http://dx.doi.org/10.2139/ssrn.4098103

Yao Chen (Contact Author)

Erasmus University Rotterdam (EUR) - Erasmus School of Economics (ESE) ( email )

P.O. Box 1738
3000 DR Rotterdam, NL 3062 PA
Netherlands

Felix Ward

Erasmus University Rotterdam (EUR) - Erasmus School of Economics (ESE) ( email )

P.O. Box 1738
3000 DR Rotterdam, NL 3062 PA
Netherlands

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