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Growth and Economic Policy: Are There Speed Limits to Real Convergence?

  • Istv�n P. Sz�kely
  • Max Watson

Real convergence in the recently acceded EU member states (RAMS) is taking place in a new environment, with important implications for convergence and vulnerabilities. Financial liberalization can increase temporary imbalances, while financial integration provides the necessary external finance to support the larger current account deficits involved. Thus, periods during which relative prices are distorted and resources are not reallocated to reach a new equilibrium can be lengthened. When prices are sticky, the exchange rate regime matters in the short run: a fixed exchange rate regime generates a larger current account deficit than a flexible exchange rate regime. That is, the extent of vulnerability to adjustment risk will depend on several factors, and trade-offs between these, including price stickiness, the extent of unhedged balance sheet exposures, and the degree of nominal flexibility afforded by the exchange rate regime. Financial liberalization and integration may also lead to sizable changes in th composition of final demand, and through this, considerable movements in the equilibrium real exchange rate. It may therefore be a challenging task for policymakers to achieve fast and steady nominal convergence in certain phases of convergence in this new environment. The paper discusses the challenges policymakers in RAMS face and the policies that can make the convergence process faster and smoother.

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Paper provided by Directorate General Economic and Financial Affairs (DG ECFIN), European Commission in its series European Economy - Economic Papers with number 294.

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Length: 25 pages
Date of creation: Dec 2007
Date of revision:
Handle: RePEc:euf:ecopap:0294
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