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Catching-up, Inflation Differentials and Credit Booms in a Heterogeneous Monetary Union: Some Implications for EMU and new EU Member States

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  • Ronald MacDonald
  • Cezary Wójcik

Abstract

In this paper we propose an alternative explanation for the nature, sources and consequences of inflation rate differentials in a monetary union, such as EMU. To achieve this, we build on the new neoclassical synthesis (NNS) framework, recently advanced by Goodfriend (2002) and Goodfriend and King (2000). Based on the NNS setup, we discuss the inflationary consequences of the catching-up process in a heterogeneous monetary union. In particular, we explore the interaction between catching-up and inflation differentials and offer an interpretation of the nature of this interaction. Our discussion is in stark contrast to the conventional Balassa-Samuelson (BS) interpretation. In particular, we demonstrate that divergent inflation rates between Member States do not necessarily have to be an equilibrium phenomenon, even if the original shock comes from the supply-side of the economy. Second, we show how a centralized monetary policy may produce such divergence of individual country’s inflation rates when countries differ in size and in trend productivity growth. Against this background, we additionally show how the catching may potentially lead to unsustainable credit booms in a catching-up member country. Finally, we indicate some important deficiencies of the BS model as a guide to short- and medium-run policy making analysis.

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Bibliographic Info

Paper provided by CESifo Group Munich in its series CESifo Working Paper Series with number 1761.

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Date of creation: 2006
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Handle: RePEc:ces:ceswps:_1761

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Keywords: inflation differentials; credit booms; new neoclassical synthesis; monetary union; EMU; Balassa-Samuelson model;

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  1. Matthew B. Canzoneri & Behzad Diba & Gwen Eudey, 1996. "Trends in European Productivity and Real Exchange Rates," Banco de España Working Papers 9610, Banco de España.
  2. Philip R. Lane & Patrick Honohan, 2003. "Divergent Inflation Rates in EMU," Trinity Economics Papers 20034, Trinity College Dublin, Department of Economics.
  3. Paul Bergin & Reuven Glick & Alan M. Taylor, 2004. "Productivity, Tradability, and the Long-Run Price Puzzle," NBER Working Papers 10569, National Bureau of Economic Research, Inc.
  4. Neary, J Peter, 1987. "Determinants of the Equilibrium Real Exchange Rate," CEPR Discussion Papers 209, C.E.P.R. Discussion Papers.
  5. Gottfries, Nils, 2003. "Booms and Busts in EMU," Working Paper Series 2003:29, Uppsala University, Department of Economics.
  6. Bela Balassa, 1964. "The Purchasing-Power Parity Doctrine: A Reappraisal," Journal of Political Economy, University of Chicago Press, vol. 72, pages 584.
  7. Froot, Kenneth A. & Rogoff, Kenneth, 1995. "Perspectives on PPP and long-run real exchange rates," Handbook of International Economics, in: G. M. Grossman & K. Rogoff (ed.), Handbook of International Economics, edition 1, volume 3, chapter 32, pages 1647-1688 Elsevier.
  8. Bergstrand, Jeffrey H, 1991. "Structural Determinants of Real Exchange Rates and National Price Levels: Some Empirical Evidence," American Economic Review, American Economic Association, vol. 81(1), pages 325-34, March.
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Cited by:
  1. Heijdra, B.J. & Ligthart, J.E., 2006. "Fiscal Policy, Monopolistic Competition and Finite Lives," Open Access publications from Tilburg University urn:nbn:nl:ui:12-199395, Tilburg University.
  2. Peter Backé & Cezary Wójcik, 2006. "Catching-up and Credit Booms in Central and Eastern European EU Member States and Acceding Countries: An Interpretation within the New Neoclassical Synthesis Framework," CESifo Working Paper Series 1836, CESifo Group Munich.
  3. Alberto Montagnoli & Andros Gregoriou & Alexandros Kontonikas, 2007. "Euro Area Inflation Differentials: Unit Roots, Structural Breaks and Non-Linear Adjustment," Working Papers 2007_13, Business School - Economics, University of Glasgow.

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