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	Cezary Wojcik, Warsaw School of Economics and Polish Academy of Sciences
	Catching-up and Inflation Differential in a Heterogeneous Currency Union. A New Neoclassical Synthesis Approach wiiw, 5 May 2003, 1 p.m.

In the present paper we propose an alternative explanation of the nature, sources and consequences of inflation rate differentials in a monetary union like EMU. In doing so, we make a simple adaptation of the new neoclassical synthesis (NNS) framework, which has been recently advanced by Goodfriend (2002) and Goodfriend and King (2000). Based on the NNS setup, we present a simple model of catching-up in a heterogeneous currency union. We explore the interaction between catching-up and inflation differentials and offer an interpretation of the nature of this interaction. Our model stands in stark contrast to the Balassa-Samuelson (BS) interpretation. First, the model demonstrates that the divergent inflation rates do not have to be necessarily an equilibrium phenomenon even if the original shock comes from the supply side of the economy. Second, the model shows how a centralized monetary policy may incite such divergence of individual countries' inflation rates when countries differ in size and in trend productivity growth. Furthermore, based on our analysis we point out some important deficiencies of the BS model as a guide for short-run and medium-run policy making analysis, even if BS can be a useful framework to think about the static relationship between the relative prices and the level of development in the long run.


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