The role of the Exchange Rate Regime in the process of Real and Nominal Convergence

This paper studies the role of the exchange rate regime in the process of price convergence in Europe. During the last decade, a large strand of literature has flourished which studies the importance of the Balassa-Samuelson hypothesis in explaining nominal convergence. However, a general result of this literature is that such hypothesis can only explain a minor part of the excess inflation registered in European catching-up countries, while other factors may be at play. The role of the exchange rate regime in convergence in Europe, however, has so far been overlooked. First, we model the (endogenous) choice of the exchange rate regime and, in a second stage, estimate a Balassa-Samuelson type of regression for each regime. The results show that, for countries which pegged to or adopted the euro, the effect of a 1% increase in dual productivity growth (i.e. the difference between traded and non-traded sector productivity growth) on the dual inflation differential is more than twice as big as that of “flexible” countries. Our results suggest that too early adoption of the euro may per se foster excess inflation in a catching-up country which cannot be accounted for by the process of real convergence.