Real Unit labor costs differentials in EMU: How big, how benign and how reversible?

This paper investigates the factors underlying the dispersion in RULC growth rates across euro area countries. It addresses three main questions. First, how big are RULC growth differentials in EMU by historical perspective? Second, what are the reasons underlying such differentials and why does growth dispersion remain after the start of EMU? Third, how can policy narrow such differentials? The theoretical model takes as a starting point a monotonic relationship between RULC and the capital-output ratio under the assumptions of perfect competition and a CES technology. Factors displacing this schedule are subsequently introduced, including changes in the price of intermediate inputs, markups of prices over marginal costs, union bargaining power and labor adjustment costs. A log-linear version of the model is then estimated on a panel of 11 euro-area countries ranging from 1980 to 2008. According to our empirical findings, persistent RULC growth differentials can be attributed to divergent evolutions in capital-output ratios, nominal effective exchange rates and country-specific institutional features, coupled with an increased sensitivity of RULC to fundamentals following the shift in the monetary regime.