(De-)Stabilizing two-country macroeconomic interactions in an estimated model of the U.S. and the Euro Area


In this paper a semi-structural macroeconomic model based on gradually adjusting wages and prices and hybrid, cross-over inflation expectation formation is analyzed and estimated with aggregate data of the U.S. and the Euro Area. Besides comparing, among other things, the determinants of the wage- and price inflation dynamics in both economies, the role of different macroeconomic transmission channels for the stability of the two-country system is investigated.

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  1. 1.

    We will, however, not engage into this debate here but rather adopt the most traditional view according to which \(\partial \Delta y/\partial v\) is unambiguously negative.

  2. 2.

    Despite of being largely criticized due to its “lack of microfoundations”, in a large number of microfounded, “rational expectations” models such as Taylor (1994), Okun’s law is used to link production with employment.

  3. 3.

    As pointed out by Sims (1987), such strategy allows to circumvent the identification problem which arises in econometric estimations where both wage and price inflation equations have the same explanatory variables.

  4. 4.

    It should be stressed that forward-looking behavior is indeed incorporated here, without the need for an application of the jump variable technique of the rational expectations school in general and of the New Keynesian approach in particular.

  5. 5.

    For a discussion of the microfoundations of the wage Phillips curve in the line of Blanchard and Katz (1999), see Flaschel and Krolzig (2006).

  6. 6.

    Recently, the overly unrealistic assumption in DSGE models as Erceg et al. (2000) of wages set by the households in a monopolistic manner has been replaced through more realistic wage setting schemes based on job search wage bargaining considerations by Trigari (2004) and Gertler and Trigari (2006), among others.

  7. 7.

    Behavioral models which incorporate heterogenous beliefs and trading strategies are much more successful in this task, as discussed for example in De Grauwe and Grimaldi (2006).

  8. 8.

    Note that, following Rudebusch (2006), we do not assume an intrinsic interest rate smoothing behavior by the monetary authorities as it is done in a large number of empirical studies, see e.g. Clarida et al. (1998).

  9. 9.

    As pointed out by p. 310 Foley (1975), “No substantive prediction or explanation in a well-defined macroeconomic period model should depend on the real time length of the period”, see also Flaschel and Proaño (2009).

  10. 10.

    At this stage it should be however pointed out that the parameter estimates for the Euro Area should be handled with care since they, despite of the many similarities in the macroeconomic development of the participant economies and the possibility of cross-country aggregation, represent the theoretical values of an artificial economy for the great part of the sample period.

  11. 11.

    In the following econometric estimations, thus, the concept of a variable NAIRU is implicitly assumed despite the fact that it was not explicitly model it in the theoretical framework of the previous section.

  12. 12.

    Note nevertheless that, by the construction of the Hodrick-Prescott filter, the calculated course of the proxy for the long-term unemployed (the smoothed series) depends on the whole sample period.

  13. 13.

    As stated in p. 92 Wooldridge (2001), a GMM estimation possesses several advantages in comparison to more traditional estimation methods such as OLS and 2SLS. This is especially true in time series models, where heteroskedasticity in the residuals is a common feature: “The optimal GMM estimator is asymptotically no less efficient than two-stage least squares under homoskedasticity, and GMM is generally better under heteroskedasticity.”

  14. 14.

    See p. 190 Wooldridge (2002).

  15. 15.

    Slightly different versions of the two Phillips curves given by Eqs. 3 and 3 have been estimated for the U.S. economy in various ways in Flaschel and Krolzig (2006), Flaschel et al. (2007), Chen and Flaschel (2006) and Chen et al. (2006) with similar results.

  16. 16.

    It should be however pointed out that we would have expected both coefficients to be larger in the Euro Area than in the U.S., according to the notion of a predominant role of the U.S. economy. Their importance, however, should not be overstated since—concerning the Euro Area—represent in a long part of the estimation sample an artificial economy.


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I would like to thank Peter Flaschel, Willi Semmler and Heike Joebges for the many helpful discussions and comments, as well as two anonymous referees for many valuable suggestions on a previous draft of this paper.

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Proaño, C.R. (De-)Stabilizing two-country macroeconomic interactions in an estimated model of the U.S. and the Euro Area. Int Econ Econ Policy 6, 421–443 (2009). https://doi.org/10.1007/s10368-009-0145-0

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  • (D)AS-AD
  • Monetary policy
  • International transmission mechanisms
  • Wage- and price inflation dynamics
  • Instability

JEL Classifications

  • E12
  • E31
  • F41