Market Regulation, Cycles and Growth in a Monetary Union

IMF Working Papers, June 3, 2019

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Built a two-country currency union DSGE model with endogenous growth to assess the role of cross-country differences in product and labor market regulations for:
- long-term growth, and
- the adjustment to shocks.
Emphasis on endogenous TFP movements as a channel through which large shocks operate.

With endogenous growth, there is no reason to expect real income convergence.
Large shocks, through endogenous TFP movements, can lead to permanent changes of:
- output, and
- real exchange rates.
Differences in outcomes are exacerbated when member countries have different product and labor market regulations.
Less regulated economies are likely to:
- have higher trend growth, and
- recover faster from negative shocks.
Results are consistent with observed outcomes in the euro area: higher inflation, lower employment and disappointing TFP growth rates experienced in the less reform-friendly euro area members.

Cross-country heterogeneity in product and labor market regulation matters for both long-run growth and cyclical adjustment within a monetary union.
Reforms that reduce regulation can be associated with higher trend growth and faster recoveries from negative shocks, implying potential trade-offs for reform policy in currency unions.

Subject: Commodity markets, Financial markets, Inflation, Labor, Labor markets, National accounts, Prices, Production, Return on investment, Total factor productivity
Keywords: business cycle, Commodity markets, Currency union, endogenous growth, Inflation, labor and product market regulation, labor market, Labor markets, Northern Europe, product market regulation, R&D investment, Return on investment, risk premium shock, Southern Europe, TFP dynamics, Total factor productivity, WP