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

Abstract
Can fixed exchange rate regimes cause output divergence among participating 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, region-specific monetary policies close output gaps and realize the associated 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 the TFP growth rate of the euro area's periphery relative to its core. Empirical tests confirm that countries with high wage inflation suffer lower TFP growth in the aftermath of fixing the exchange rate. Joint paper with Felix Ward.