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Wage divergence, business cylce co-movement and the currency union effect

Martin Gächter (), Alexander Gruber () and Aleksandra Riedl ()

No 1605, Economics Working Paper Series from University of St. Gallen, School of Economics and Political Science

Abstract: The European debt crisis reminded us that some member countries of Economic and Monetary Union (EMU) experienced unsustainable pre-crisis booms accompanied by an increase in wages far beyond what would have been justified by long-lasting trends in labor productivity. Within a currency union, such diverging trends in wages and competitiveness cannot be mitigated by simply adjusting nominal exchange rates. Against this background, it is astonishing that the impact of labor cost dynamics on business cycle co-movement – the most widely used meta-criterion for an optimum currency area – has not been analyzed so far. In our empirical analysis, we reveal a highly significant and policy-relevant finding: While wage developments do not affect business cycle convergence outside a currency union, wage growth differentials across countries significantly reduce business cycle co-movement within a common currency area. The economic significance of the effect is surprisingly large and even exceeds the impact of bilateral trade relations.

Keywords: Business Cycle Synchronization; Unit Labor Costs; Competitiveness; Currency Union; Optimum Currency Area (search for similar items in EconPapers)
JEL-codes: E31 E32 F44 (search for similar items in EconPapers)
Pages: 36 pages
Date: 2016-03
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