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Output Divergence in Fixed Exchange Rate Regimes: Is the Euro Area Growing Apart?

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  • Chen, Yao
  • Ward, Felix

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.

Suggested Citation

  • Chen, Yao & Ward, Felix, 2023. "Output Divergence in Fixed Exchange Rate Regimes: Is the Euro Area Growing Apart?," CEPR Discussion Papers 17902, C.E.P.R. Discussion Papers.
    • Handle: RePEc:cpr:ceprdp:17902
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    More about this item

    JEL classification:

    • E50 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - General
    • F31 - International Economics - - International Finance - - - Foreign Exchange
    • O40 - Economic Development, Innovation, Technological Change, and Growth - - Economic Growth and Aggregate Productivity - - - General

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