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Home | Events Archive | Growing Apart: Income Divergence in Fixed Exchange Rate Regimes

Growing Apart: Income Divergence in Fixed Exchange Rate Regimes

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    June 24, 2021
    12:00 - 13:00

Can fixed exchange rate regimes cause income divergence among member states? We show that such 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, monetary policy closes output gaps and realizes the associated maximum TFP growth in both regions. Upon fixing exchange rates, the region with higher structural wage inflation falls into a low-growth trap. When calibrated to the euro area, the model implies that absent policies that stave off low-growth traps, area membership comes with the risk of diverging incomes and large welfare losses.

joint work with Felix Ward