Macroeconomic adjustment and heterogeneity in the euro area

Andrzej Toroj
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Andrzej Toroj: Warsaw School of Economics, http://www.sgh.waw.pl

No 54, National Bank of Poland Working Papers from National Bank of Poland, Economic Institute

Abstract: 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.

Keywords: EMU; euro area heterogeneity; competitiveness channel; real interest rate effect; GMM; solution of RE models (search for similar items in EconPapers)
JEL-codes: C32 C61 F15 E52 (search for similar items in EconPapers)
Date: 2009-01
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