Academic journal article International Advances in Economic Research

The Global Financial Crisis and Stochastic Convergence in the Euro Area

Academic journal article International Advances in Economic Research

The Global Financial Crisis and Stochastic Convergence in the Euro Area

Article excerpt

Abstract This paper analyzes the issue of convergence in the original Euro Area countries, and assesses the effect of the global financial crisis on the process of convergence. In particular, we consider whether the global financial crisis pulled the 12 economies of the Euro Area together or pushed them apart. We investigate the dynamics of stochastic convergence of the original Euro Area countries for inflation rates, nominal interest rates, and real interest rates. We test for convergence relative to Germany, taken as the benchmark for core EU standards, using monthly data over the period January 2001 to September 2010. We examine, in a time-series framework, three different profiles of the convergence process: linear convergence, nonlinear convergence, and linear segmented convergence. Our findings both contradict and support convergence. Stochastic convergence implies the rejection of a unit root in the inflation rate, nominal interest rate, and real interest rate differentials. We find that the differentials are consistent with a unit-root hypothesis when the alternative hypothesis is a stationary process with a linear trend. We frequently, but not always, reject the unit-root hypothesis when the alternative is a stationary process with a broken trend. We also note that the current financial crisis plays a significant role in dating the breaks.

Keywords Stochastic convergence * Nonlinearity * Unit-root tests * Structural breaks

JEL F36 * F42 * C20 * C50

Introduction

In January 1999, 11 countries of the European Union (EU) formed an economic and monetary union (EMU) that officially became known as the Euro Area or Euro Zone. They abandoned their respective national currencies and relinquished their monetary independence to adopt a common currency, the euro These countries are Austria, Belgium, Finland, France, Germany, Ireland, Italy, Luxemburg, the Netherlands, Portugal, and Spain. Greece adopted the euro in January 2001. Since 1999, the European Central Bank (ECB) conducts monetary policy. Denmark, Sweden, and the United Kingdom maintain their own currencies and monetary independence.

The EU, as we know it today, was born out of the Maastricht Treaty (1992), which created the legal, institutional, monetary, and fiscal framework of the EMU (see Eichengreen and "Wyplosz 1993 for more details). The Maastricht Treaty requires that the countries in the Euro Zone achieve real and financial integration. After the inception of the euro, however, we witness a growing number of apparent divergences, especially in connection with the current financial crisis. The relevant literature, however, does not y1193-8308-139001-25011024et determine whether these divergences constitute temporary events or represent the manifestation of more structural phenomena.

This paper analyzes the issue of convergence in the original Euro Area countries, and assesses the effect of the global financial crisis on the process of convergence. (1) In particular, we consider whether the global financial crisis pulled the 12 economies of the Euro Area together or pushed them apart.

We analyze three aspects of convergence. First, we consider whether inflation differentials persist in the Euro Area. (2) Persistent inflation differences complicate the ECB's monetary policy, as the common interest rate policy may prove too lax for some countries and too strict for others. As such, a single monetary policy, one size fits all, cannot efficiently fight inflation within the Euro Area. Countries with slow growth, high unemployment, and a large trade deficit, such as Greece, Italy, and Portugal, may want to leave the Euro Area to ease monetary conditions and devalue their currencies. Similarly, other countries, such as Germany that prefer tougher monetary policy, may want to leave the Euro Area to pursue a tighter policy. Alternatively, regional inflation differentials may only reflect differences in productivity growth, the well-known Balassa-Samuelson effect. …

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