Javier Andres - Samuel Hurtado - Eva Ortega - Carlos Thomas: Spain in the Euro: A General Equlibrium Analysis Ágnes Csermely Magyar Nemzeti Bank

Spain and the rest of the Euro Area differ in terms of growth and inflation performance Both average growth and average inflation are higher in Spain –Well-documented finding in the growth literature (convergence in income convergence in prices) Also: cyclical performances are different Focus of this paper: What are the sources of cyclical differences? Scope of the paper

Aim of the project To make use of BEMOD (Banco de Espana DSGE model) To understand the sources of cyclical growth and inflation differentials –Asymmetric country-specific shocks vs. asymmetric economic structure –Effect of EMU membership on differentials

Main results Estimation reveals sizeable idiosyncratic shocks + differences in structural parameters Cyclical (demeaned) growth differentials stem mostly from idiosyncratic shocks Cyclical (demeaned) inflation differentials reflect both idiosyncratic shocks and asymmetric economic structure –Common shocks (i.e. oil prices) have different effects due to structural asymmetries Independent monetary policy could have reduced cyclical differentials

Why do we want to know the sources of differentials? Should they be reduced? –Optimal currency area arguments suggest yes Can we reduce them? –Yes, if they come from Spain-specific policy shocks or Spain-specific regulations Are they dying out naturally in the convergence process? –Yes, if they come from differences in structural parameters that we believe to be related to initial conditions (more flexibility in price setting may reflect the higher inflation environment?)

Structural interpretation "They [DSGE models] have become popular [...] because the sources of fluctuations have clear structural interpretation." Good news. But: do they really? Some puzzling results: –Spain-specific mark-up shocks explain the bulk of CPI inflation in Spain and inflation differential to the Euro Area. –Most important shocks are those related to price and wage setting (cost-push shocks). –Nominal phenomena are explained residually?

Policymakers often find DSGE models too technical, analysis could rely more on intuition (story-telling). A DSGE statement: "A clear example is the year 2001, where the rest-of-the-World shocks had a positive effect on Spanish inflation but a negative effect on rest-of-EMU inflation." A policymaker question: what exactly happened in 2001? –Was it rising oil prices (and Spain having a larger share of oil in production/consumption)? –Was it euro appreciation (and rest-of-EMU having of larger share of ROW-imports)? –Was it US recession (and rest-of-EMU being more relied on trade with the US)? More story-telling is most welcome

There is a clear positive average growth and inflation differential We have reasons to believe that the differentials are non-stationary –A neoclassical convergence story would imply diminishing trend for differentials Is simple demeaning the right way to stationarize the data? Trend or cycle?

Very rich setup with emphasis on supply-side effects –The 21 structural shocks are mostly related to country-, sector- or investment-specific technologies Demand-side effects are not very sophisticated –Ricardian fiscal policy shock –Time preference shock If we are interested in the short run (cyclical properties), a more detailed view on the AD side would come useful –Non-Ricardian fiscal policy, relative preference shocks, and some financial intermediation ("domestic risk premium") Predominant role for the supply-side

Normative implications Independent monetary policy in Spain would have reduced both inflation and growth differentials. –Common monetary policy is costly in terms of welfare Role of fiscal policy becomes more important in smoothing out cyclical fluctuations –This calls for a more detailed and empirically more relevant view of fiscal policy in the model

Conclusions Differentials in growth and inflation persist over the longer run Cyclical component of growth differentials come mostly from idiosyncratic shocks –Asymmetric policy measures should be reduced? Cyclical component of inflation differentials come from both idiosyncratic shocks and structural asymmetries –With convergence, inflation should (by itself) become more synchronized?