Please use this identifier to cite or link to this item: https://hdl.handle.net/10419/212005 
Year of Publication: 
2005
Series/Report no.: 
Bank of Finland Research Discussion Papers No. 7/2005
Publisher: 
Bank of Finland, Helsinki
Abstract: 
Differences in growth, productivity and inflation levels are going to be a prominent feature of the future of EMU, as the convergence process is still on-going in the new Member States. This convergence process can be described by the Balassa-Samuelson proposition, which states that faster growth in the traded goods sector than in the non-traded goods sector results in a rise in the price of non-traded goods and an appreciation of the trend real exchange rate. In this study, the aim is to construct a small open economy model that enables examination of the effects of Balassa-Samuelson-type growth in an intertemporal fixed exchange rate framework with a focus on the external balance. To address the well-known problems with small open economy models, an endogenous discount rate is used. The results imply that faster productivity growth in the traded than in the non-traded goods sector may induce external imbalances, leading to increased vulnerability of the economy. However, trade account deficits would appear to be a temporary phenomenon, as this line of development can be reversed by the natural shift in the composition of consumption towards non-traded goods that is characteristic of catch-up economies. In the meantime, fiscal policy plays a key role.
Subjects: 
small open economy
Balassa-Samuelson effect
ERM II
external balance
JEL: 
F41
F33
F32
Persistent Identifier of the first edition: 
ISBN: 
952-462-203-3
Document Type: 
Working Paper

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