...hypothesis, economic growth associated with appreciation of the real exchange rate because of larger productivity growth differentials between tradable and non-tradable sectors in developing countries relative to high-income countries. Empirical research has shown that this phenomenon is particularly relevant for emerging market economies (EMEs) and countries in transition from centrally planned to market economies, where large productivity gains tend to be (at least initially) concentrated in the tradable sector.

To the extent that a productivity-driven appreciation of the real exchange rate can manifest itself as an appreciation of the nominal exchange rate and/or higher inflation, the choice of monetary and exchange rate policy has important implications for the dynamics of nominal variables. This issue is important for Eastern and Central European countries that joined the European Union (EU) in 2004 and are set to join the Euro area sometime in the future. These countries could potentially face an important trade-off between complying with two Euro area admission criteria: the inflation limit set by the Maastricht Treaty, and the membership in the Exchange Rate Mechanism (ERM), limiting movements of the nominal exchange rate against the Euro. More generally, the issue is important for EMEs engaged in active management of their nominal exchange rate--for example, some fast-growing Asian countries--as the equilibrium appreciation of the real exchange rate has the potential to generate unwanted inflation pressures.

Using a general equilibrium model of an EME, we evaluate alternative monetary and exchange rate regimes in the event of a productivity-driven appreciation of the real exchange rate. We investigate both the dynamic properties of this economy and the welfare implications of these alternative policies. Our main findings are the following. First, we show that the response of real variables is largely independent of the monetary policy regime. The economy experiences a consumption boom, a surge in imports, and an increase in the production of the non-tradable good under both a fixed exchange rate regime and an inflation targeting regime. Because the long-term productivity gain is anticipated, the increase in consumption is financed through a large capital inflow. Second, the general equilibrium framework allows us to compute the inflation-exchange rate volatility trade-off as a function of the monetary policy regime and to analyze the extent to which this volatility trade-off is influenced by the B-S effect. We find that the equilibrium appreciation of the real exchange rate regime narrows considerably the range of policy rules which, with a given probability, keep the exchange rate and the inflation rate within specified numerical targets. Third, we show that the B-S effect has important consequences for the relative welfare performance of alternative policy rules. More specifically, we find that the B-S effect increases by an order of magnitude the welfare loss (relative to the best-performing rule) associated with monetary policy rules which prescribe an aggressive reaction to deviations of the exchange rate from a desired target level.

The paper is organized as follows. Section I reviews the recent literature on the B-S effect. Section 2 describes the model and Section 3 evaluates the macro-economic consequences of an equilibrium appreciation of the real exchange rate under alternative monetary and exchange rate regimes. Section 4 derives the inflation-exchange rate variance trade-off and performs welfare comparisons under alternative policy rules. Section 5 concludes. The Appendix contains a detailed description of the model equilibrium conditions, parameterization, and solution algorithm.

1. BALASSA-SAMUELSON EFFECT AND MACRO-ECONOMIC IMPLICATIONS

Faster productivity growth in EMEs relative to more advanced countries can produce a trend appreciation of the real exchange rate through the so-called Balassa-Samuelson effect (Balassa 1964). Most of the productivity gains experienced by developing countries are concentrated in the tradable good sector. Higher productivity translates into higher wages; assuming perfect labor mobility across sectors, wages in the non-tradable sector need to rise as well. Firms in the non-tradable sector, facing relatively lower productivity gains, are then forced to increase prices. The ratio of [P.sub.T]/[P.sub.N] (the internal real exchange rate) will then decline. If tradable to non-tradable prices the law of one price holds for tradable goods, a larger productivity growth differential between the tradable and non-tradable sector relative to the rest of the world implies an appreciation of the CPI-based real exchange rate [EP.sup.*.sub]/P, that is, a decrease in the nominal exchange rate E adjusted for price level differences between domestic (P) and foreign ([P.sup.*]) CPI.

The group of countries that joined the EU in May 2004 is an example of economies that have been experiencing high productivity growth relative to the Euro-area-indicating that the process of catch-up is still ongoing--and a sustained appreciation of the real exchange rate (see Figure 1). (1) These 10 countries--Cyprus, the Czech Republic, Estonia, Hungary, Latvia, Lithuania, Malta, Poland, Slovakia, and Slovenia--are expected, at some point, to adopt the Euro as their official currency. Because entry into the Economic and Monetary Union (EMU) requires compliance with the Maastricht convergence criteria, the experience of the new EU members is an interesting case study which allows us to analyze how the equilibrium appreciation of the real exchange rate interacts with the choice of the monetary and exchange rate regime. (2)

The B-S effect has been explored also in other EMEs where strong economic growth is combined with a sustained appreciation of the real exchange rate. For example, Ito, Isard, and Symansky (1999) test the B-S hypothesis using data from APEC economies. They show that Japan, South Korea, Taiwan and, in part, Hong Kong and Singapore followed a similar industrialization pattern--the B-S path-increasing over time the weight of high value-added exports. Not all fast-growing countries in the region, however, experienced an appreciation of the real exchange rate. They interpret these findings as suggesting that the applicability of the B-S hypothesis depends on the development stage of the economy.

[FIGURE 1 OMITTED]

More generally, there is disagreement as to whether productivity growth differentials can fully explain large appreciations of the real exchange rate (see, e.g., Mihaljek 2004). In fact, changes in the CPI-based real exchange rate can be disaggregated into three components: (i) the ratio of the relative price [P.sub.T]/[P.sub.N] in the developing country relative to the more advanced country, (ii) changes in the shares of tradable and non-tradable goods in the consumption basket, and (iii) the relative price of tradable goods in a common currency. Only movements in the first component correspond to the B-S effect. Egert et al. (2006) find that price level convergence in Central and Eastern European countries is taking place, at least in part, through an increase in the price of tradable goods. Clearly, if firms can price discriminate across countries, the law of one price for tradable goods does not hold. (3) Coricelli, Bostjan, and Masten (2003), however, find evidence of a strong pass-through from nominal exchange rates to domestic inflation in Hungary, Slovenia, Czech Republic, and Poland. Since the cost of non-tradable inputs can affect in various degrees the price of tradable goods (as documented for EU countries by Crucini, Telmer, and Zachariadis 2005), part of the increase in tradable good prices may also be accounted for by the B-S effect.

While the discussion in the literature generally focuses on the magnitude of the B-S effect, the quantitative analysis of its implications for monetary policy is fairly limited. Devereux (2003) is the closest to the model developed in this paper, even though the focus of his analysis is on the role of terms of trade shocks in new EU members. Laxton and Pesenti (2003) examine alternative Taylor rules in a general equilibrium model calibrated to the Czech Republic.

2. THE MODEL

We build a model of a small open economy along the lines of Obstfeld and Rogoff (2000), Devereux (2001, 2003), Devereux and Lane (2006), and Gali and Monacelli (2005). Our goal is to have a framework that fits important characteristics of EMEs, including rapid productivity growth; vulnerability to external shocks through imported consumption goods, intermediate inputs, and the foreign component of capital goods; and large capital inflows.

The small open economy produces a non-tradable good (N) and a domestic tradable good (H). The latter is also produced abroad and its price is exogenously determined in the world market. Consumers work in both production sectors. Their preferences are defined over a basket of tradable (T) and non-tradable (N) goods. The tradable good is itself a basket of two goods: an imported foreign good (F) and a domestically produced good (H). Consumers own the sector-specific capital, investment goods are obtained by combining the tradable and non-tradable goods. Given the structure of investment, an increase in capital in any sector requires an increase in production in all sectors. The domestic tradable sector inputs are domestic value added--a Cobb-Douglas aggregate of labor and capital--and an imported intermediate input. Output in the non-tradable sector is obtained by combining labor and capital. To introduce a role for monetary policy, we assume nominal price rigidities in the non-tradable sector.

Four distinguishing features make the model appropriate for EMEs. First, the domestic tradable good is both exported and consumed by domestic households. As a result, consumption of tradable goods does not have to be met exclusively with imports. Second, the model can account for the fact that intermediate inputs and capital goods are the main components of total imports, making the economy potentially very exposed to external shocks. In addition, foreign goods enter also the production function of the non-tradable good through capital accumulation. Third, the model allows for different elasticities of substitution between tradable and non-tradable goods, and between domestic and foreign-produced goods. Fourth, in order to analyze the implications of the B-S effect for inflation and nominal exchange rate, we...

NOTE: All illustrations and photos have been removed from this article.



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