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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

  • Ronald MacDonald
  • Cezary Wójcik

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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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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  1. Neary, Peter, 1988. "Determinants of the Equilibrium Real Exchange Rate," American Economic Review, American Economic Association, vol. 78(1), pages 210-15, March.
  2. Leon Podkaminer, 2003. "Analytical notes on the Balassa-Samuelson effect," Banca Nazionale del Lavoro Quarterly Review, Banca Nazionale del Lavoro, vol. 56(226), pages 207-221.
  3. Bela Balassa, 1964. "The Purchasing-Power Parity Doctrine: A Reappraisal," Journal of Political Economy, University of Chicago Press, vol. 72, pages 584.
  4. 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.
  5. Paul Bergin & Reuven Glick & Alan M. Taylor, 2004. "Productivity, tradability, and the long-run price puzzle," Working Paper Series 2004-08, Federal Reserve Bank of San Francisco.
  6. 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.
  7. Matthew B. Canzoneri & Behzad Diba & Gwen Eudey, 1996. "Trends in European Productivity and Real Exchange Rates," Banco de Espa�a Working Papers 9610, Banco de Espa�a.
  8. Gottfries, Nils, 2003. "Booms and Busts in EMU," Working Paper Series 2003:29, Uppsala University, Department of Economics.
  9. Philip R. Lane & Patrick Honohan, 2003. "Divergent Inflation Rates in EMU," Trinity Economics Papers 20034, Trinity College Dublin, Department of Economics.
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