Scandinavian Working Papers in Economics
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Bank of Finland Research Discussion Papers, Bank of Finland

No 7/2005:
Productivity differentials and external balance in ERM II

Marketta Henriksson ()

Abstract: Differences in growth, productivity and inflation levels are going to be a prominent feature of the future of EMU, as the convergence process is still on-going in the new Member States. This convergence process can be described by the Balassa-Samuelson proposition, which states that faster growth in the traded goods sector than in the non-traded goods sector results in a rise in the price of non-traded goods and an appreciation of the trend real exchange rate. In this study, the aim is to construct a small open economy model that enables examination of the effects of Balassa-Samuelson-type growth in an intertemporal fixed exchange rate framework with a focus on the external balance. To address the well-known problems with small open economy models, an endogenous discount rate is used. The results imply that faster productivity growth in the traded than in the non-traded goods sector may induce external imbalances, leading to increased vulnerability of the economy. However, trade account deficits would appear to be a temporary phenomenon, as this line of development can be reversed by the natural shift in the composition of consumption towards non-traded goods that is characteristic of catch-up economies. In the meantime, fiscal policy plays a key role.

Keywords: small open economy; Balassa-Samuelson effect; ERM II; external balance; (follow links to similar papers)

JEL-Codes: F32; F33; F41; (follow links to similar papers)

36 pages, February 1, 2005

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