Nominal versus real convergence with respect to EMU accession: how to cope with the Balassa-Samuelson dilemma

Abstract

This paper explores the conflict of real and monetary convergence during the EMU run-up of the future Central and Eastern European (CEE) EU member states. Based on a Balassa-Samuelson model of productivity driven inflation, it compares the policy options which might make the compliance possible, i.e., fiscal tightening and nominal appreciation within the ERM2 band. Nominal appreciation within ERM2 seems the better option to achieve the compliance with the Maastricht criteria as no discretionary government intervention is necessary and losses in terms of real growth are less. Having once opted for nominal appreciation within ERM2 by fixing the ERM2 entry rate as the ERM2 central rate (Irish model), a high degree of flexibility is provided in coping with erratic short-term capital inflows. Setting the ERM2 entry rate below or above the ERM2 central rate (Greek model) implies a clear exchange rate path within ERM2 and thereby less exchange rate volatility. But the Greek model also requires accurate information about the future exchange rate path and strict fulfilment of the Maastricht criteria within the projected time frame. Despite the merits of nominal appreciation, countries committed to hard euro pegs might choose fiscal contraction as the second best solution.

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