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Macroeconomic adjustment and heterogeneity in the euro area

We revisit the subject of country-level macroeconomic adjustment in the euro area in theabsence of autonomous monetary and exchange rate policy. We discuss how the procyclical real interest rate mechanism and the competitiveness channel of adjustment interact with various aspects of cross-country heterogeneity. Long-term differentials in steady-state inflation (due to structural factors, such as Balassa-Samuelson effect) and natural interest rate do not rule out the existence of an equilibrium, as long as they are offset by additional price level differentials. GMM estimates of the parameters of our stylized New Keynesian model imply that the competitiveness channel is effectively at work in EMU 12 in the sense of real exchange rate influence on the output gap, but market flexibility necessary to triggershifts in REER remains below the standards in New Keynesian empirical literature. They also suggest that the risk of the real interest rate effect is additionally reduced by low output gap responsiveness to country-specific real interest rates and mainly results from intrinsic inflation persistence. Our model does not confirm the existence of a premium when foreign markets are more rigid in relative terms. Promoting market flexibility, combating intrinsic inflation persistence and anchoring inflation expectations remain the main challenges for policymakers.

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Paper provided by National Bank of Poland, Economic Institute in its series National Bank of Poland Working Papers with number 54.

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Length: 43
Date of creation: Jan 2009
Date of revision:
Handle: RePEc:nbp:nbpmis:54
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  7. Marcin Kolasa, 2008. "Structural heterogeneity or asymmetric shocks? Poland and the euro area through the lens of a two-country DSGE model," National Bank of Poland Working Papers 49, National Bank of Poland, Economic Institute.
  8. von Hagen, Jürgen & Hofmann, Boris, 2003. "Macroeconomic implications of low inflation in the euro area," ZEI Working Papers B 29-2003, ZEI - Center for European Integration Studies, University of Bonn.
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  16. Altissimo, Filippo & Benigno, Pierpaolo & Rodriguez Palenzuela, Diego, 2005. "Long-Run Determinants of Inflation Differentials in a Monetary Union," CEPR Discussion Papers 5149, C.E.P.R. Discussion Papers.
  17. Peter Hoeller & Claude Giorno & Christine de la Maisonneuve, 2004. "One Money, One Cycle?: Making Monetary Union a Smoother Ride," OECD Economics Department Working Papers 401, OECD Publishing.
  18. Honohan, Patrick & Lane, Philip R., 2004. "Exchange Rates and Inflation Under EMU: An Update," CEPR Discussion Papers 4583, C.E.P.R. Discussion Papers.
  19. Stephan Sauer & Jan-Egbert Sturm, 2003. "Using Taylor Rules to Understand ECB Monetary Policy," CESifo Working Paper Series 1110, CESifo Group Munich.
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