Persistent Global Growth Differences and Euro Area Adjustment: Real Activity, Trade and the Real Exchange Rate

Abstract

Based on an estimated two-region dynamic general equilibrium model, we show that the persistent productivity growth differential between the Euro Area (EA) and rest of the world (RoW) has been a key driver of the EA trade surplus since the launch of the Euro. A secular decline in the EA’s spending home bias and a trend decrease in relative EA import prices account for the stability of the EA real exchange rate, despite slower EA output growth. By incorporating trend shocks to growth and trade, the analysis departs from much of the open-economy macroeconomics literature which has focused on stationary disturbances. Our results highlight the relevance of non-stationary shocks for the analysis of external adjustment. Joint paper with Adrian Afrim (European Commission), Philipp Pfeiffer (European Commission), Marco Ratto (European Commission) and Werner Roeger (DIW Berlin, KU Leuven).