Competitiveness channel in Poland and Slovakia: a pre-EMU DSGE analysis

Once a country joins a monetary union, an efficient competitiveness channel is considered to be the main substitute for the abandoned autonomous monetary and exchange rate policy. This paper attempts to make an empirical assessment of how the price competitiveness of domestic producers stabilizes the Polish and Slovak economies against the background of potentially procyclical real interest rates in EMU. To address this issue, we use a small open economy DSGE model. We compare the FIML estimates and resulting IRFs for Poland and Slovakia, concluding that the latter country seems in general to be more capable of handling asymmetric shocks under the common monetary policy. Also, if there was a natural interest rate disparity of 1 percentage point in favour of a catching-up economy and agents expected a 30-year long period of closing this gap, our model would predict a terms of trade appreciation for both countries in question, whereby the required appreciation would be more pronounced for Poland than for Slovakia (5.1% and 3.4% respectively). In the context of Slovak revaluations in ERM II, this could be taken into consideration when setting the final conversion rate, along with its further pros and cons.