Working Paper: CEPR ID: DP17902
Authors: Yao Chen; Felix Ward
Abstract: We show that output divergence is a long-run equilibrium characteristic of a two-region model with fixed exchange rates, heterogeneous labor markets, and endogenous growth. Under flexible exchange rates, region-specific monetary policies realize the maximum TFP growth in both regions. Upon fixing exchange rates, the common monetary policy pushes the region with higher wage inflation into a low-growth trap. When calibrated to the euro area, the model implies a slowdown in TFP growth in the euro area’s periphery relative to its core. Empirical tests confirm that countries with high wage inflation suffer lower TFP growth upon fixing the exchange rate.
Keywords: money nonneutrality; open economy; monetary policy; economic growth
JEL Codes: E50; F31; O40
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Fixed exchange rates (F31) | Diverging growth paths (O49) |
| Loss of regional monetary policy autonomy (F36) | Restriction of ability to achieve full employment and maximum TFP growth (O49) |
| High wage inflation (J31) | Lower TFP growth after fixing exchange rates (O24) |
| High wage inflation (J31) | Lower GDP per capita after fixing exchange rates (F31) |
| High wage inflation (J31) | Higher unemployment rate after fixing exchange rates (F66) |
| High wage inflation (J31) | Lower R&D spending after fixing exchange rates (O39) |
| Introduction of the euro (F36) | Decline in annual long-run GDP growth rate of the periphery (F62) |
| Decline in annual long-run GDP growth rate of the periphery (F62) | 9% output shortfall after ten years (E23) |