Demand Shocks and Equilibrium Relative Prices in the Euro Area

This paper develops a two-sector, two-country model with monopolistic competition for a currency area. Within this framework we show that the same relative productivity and price trends suggested by the literature on the Balassa - Samuelson effect can be generated by shifts in expenditure shares that lead the existing capital stock in the currency area to move towards those sectors experiencing a rise in relative demand. Focusing on regional and sectoral inflation differentials across member countries of the European Monetary Union we find support for this demand-side explanation.