Cyclical Inflation divergence and different labor market institutions in the EMU

Despite the creation of a single currency, cyclical inflation differentials are still pronounced in the Euro area and country data show that remarkable differences are still present in labor market institutions. This paper tries to asses the link between these two facts by using a DSGE
model for a currency area with sticky prices and labor market frictions. We show that differences in labor market institutions account well for cyclical inflation differentials. The proposed mechanism is a supply side one in which differences in labor market institutions generate different dynamics in real wages and consequently in marginal costs and inflations. We test this mechanism in the data and find that the model replicates well the empirical facts.

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