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

Ronald MacDonald () and Cezary Wojcik

No CESifo Working Paper No. 1761, CESifo Working Paper Series from CESifo Group Munich

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.

Keywords: inflation differentials; credit booms; new neoclassical synthesis; monetary union; EMU; Balassa-Samuelson model (search for similar items in EconPapers)
JEL-codes: F30 (search for similar items in EconPapers)
New Economics Papers: this item is included in nep-eec and nep-mon
Date: 2006
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