Market Regulation, Cycles, and Growth Dynamics in a Monetary Union

Abstract

We build a two‐country currency union dynamic stochastic general equilibrium (DSGE) model with endogenous growth to assess the role of product market regulation (PMR) and labor market regulation (LMR) for growth and the adjustment to shocks. We show that with endogenous growth, there is no reason to expect real income convergence. Large shocks can lead to permanent changes of output and real exchange rates. Differences are exacerbated by different PMR and LMR. Less regulated economies have higher trend growth and recover faster from negative shocks. Results are consistent with higher inflation, lower employment, and disappointing total factor productivity (TFP) growth rates experienced in more regulated euro area members.