The Role of the Exchange Rate Regime in the Process of Real and Nominal Convergence

33 Pages Posted: 5 Oct 2013

See all articles by Gaetano D'Adamo

Gaetano D'Adamo

University of Valencia

Riccardo Rovelli

Alma Mater Studiorum - Università di Bologna; IZA Institute of Labor Economics

Abstract

During the last decade, economists have intensively searched for evidence on the importance of the Balassa-Samuelson (B-S) hypothesis in explaining nominal convergence. One general result is that B-S can at best explain only part of the excess inflation observed in the European catching-up countries, which suggests that other factors may be at play. In these and related studies, however, the potential role of the exchange rate regime in affecting price convergence in Europe has been overlooked. In this respect, we claim that the choice of the exchange rate regime has decisively affected the path of nominal convergence. To show this, we first model the (endogenous) choice of the exchange rate regime and, in a second stage, estimate a B-S type of regression for each regime. Our results show that, for countries which pegged to or adopted the euro, the effect of the same increase in the dual productivity growth (that is, the difference in productivity growth between the traded and non-traded sectors) on the dual inflation differential is more than twice as large as that in the "flexible" countries. We conclude that, in a catching-up country, premature euro adoption may foster excess inflation, beyond that which is to be expected as a consequence of productivity convergence on the basis of the B-S effect.

Keywords: exchange rate regimes, Balassa-Samuelson effect, inflation, euro adoption

JEL Classification: C34, E52, F31

Suggested Citation

D'Adamo, Gaetano and Rovelli, Riccardo, The Role of the Exchange Rate Regime in the Process of Real and Nominal Convergence. IZA Discussion Paper No. 7627, Available at SSRN: https://ssrn.com/abstract=2336424 or http://dx.doi.org/10.2139/ssrn.2336424

Gaetano D'Adamo (Contact Author)

University of Valencia ( email )

No Address Available

Riccardo Rovelli

Alma Mater Studiorum - Università di Bologna ( email )

Bologna
Italy

IZA Institute of Labor Economics ( email )

P.O. Box 7240
Bonn, D-53072
Germany

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