Optimal monetary policy with Balassa-Samuelson-type productivity shocks

This paper develops a two-sector small open-economy dynamic stochastic general equilibrium model with price rigidities and permanent technology shocks that allow for simulation of the differential productivity growth (Balassa-Samuelson-type productivity improvement). In addition, the model incorporates quality improvement of products to replicate the dynamics of terms of trade in new EU members. The model is calibrated for a typical new EU member country to asses whether the Balassa-Samuelson effect poses a threat to fulfilling the inflation Maastricht criterion. In addition, optimal policy is derived for a benchmark parameterization of the model using second-order approximation to the utility function of the representative consumer. The results show that productivity growth differential need not generate the inflationary effects that represent significant risks to fulfilling Maastricht criteria and that this objective can be optimally achieved within the ERM II. Journal of Comparative Economics 36 (1) (2008) 120-141.