Wage Divergence, Business Cycle Co‐Movement and the Currency Union Effect

Abstract

This paper studies the impact of wage growth divergence on business cycle co-movement in the context of currency unions. While the theoretical literature on optimum currency areas highlights the equilibrating effect of divergent wage growth after asymmetric exogenous demand shocks via the external demand channel, recent literature on euro area imbalances emphasizes its disequilibrating effect as a source of asymmetric domestic demand shocks, and therefore suggests a negative link to business cycle co-movement. Our empirical results reveal that the latter effect has been clearly dominating in the euro area: Wage growth differentials across countrieswhile of minor importance for non-euro area EU countries with sovereign currenciessignificantly reduce business cycle co-movement within the monetary union and thus increase the cost of the common monetary policy. The large magnitude of the effect calls for enhanced co-ordination efforts of wage policies in the euro area.

Macroeconomic imbalances and business cycle synchronization. Why common economic governance is imperative for the Eurozone

“…Excessive increases in real wages would surge output while declining wages cut demand and result in output losses. This result is in line with the recent findings of Gächter et al (2016).…”

“…Real unit labor cost developments have seen mainly periods of dissimilarity in the EA, interrupted by a short period of more similar developments during the debt crisis (see Figure 6), as pointed out also in Estrada et al (2013) and Felipe and Kumar (2014). We will test whether different unit labor cost developments improve or reduce BCS which hardly has been investigated in the literature, with the recent exception of Gächter et al (2016). Besides the impact of the scoreboard indicators: current account, government deficit, public debt, private debt and unit labor cost development, we will test the impact of additional indicators of the scoreboard list within the auxiliary equations of our model and present conjectures on their effect in the discussion of the model in the next section.…”

“…Thus different wage developments may serve BCS. However, excessive wage demands or undue wage restrictions in a country and the ensuing immediate demand effects can lead to overheating of the concerned economy and result in a reduction of BCS (Gächter et al, 2016). Since there are no complete statistics on quarterly wage developments we focus on real unit labor cost developments as a proxy.…”

Fiscal policy, government size and EMU business cycle synchronization

“…More specifically, this study shows that trade exercises a highly significant effect on business cycle synchronization across the country‐pairs. The positive effects of bilateral trade intensity on business cycle synchronization confirm a long list of previous studies, which find trade to be important in explaining business cycle synchronization (see for example Gächter et al, ). This is expected given that when a country experiences an increase in its productivity, this will lead to higher output and income, which, in turn, will lead to higher imports for intermediate goods (productivity effects) as well as finished goods (income effects) from its trading partner.…”

“…This claim is rather important as the fact that the level of synchronization might be impacted by fiscal policy decisions and other institutional features, has been rather neglected by the literature. There are only a handful of studies focusing on the potential impact of fiscal policy on business cycle synchronization (see, for instance, Gächter, Gruber, & Riedl, ; Inklaar, Jong‐A‐Pin, & Haan, ). Interestingly, there is no consensus among this limited number of studies as to whether fiscal policy can increase business cycle synchronization.…”