Real convergence and its illusions

This paper uses a multi-country dynamic general equilibrium model to illustrate real convergence processes in a small open catching-up economy. Our results indicate that even if the convergence is driven by smoothly evolving processes, the dynamic adjustments of key macrovariables can be far from smooth. We also demonstrate that overly optimistic expectations about current or future productivity shifts can generate sizable boom-bust cycles. A comparison across alternative monetary regimes reveals that a flexible exchange rate helps to smooth real convergence processes and misperceptions associated with tradable sector productivity, while it generates more volatility in scenarios based on nontradable sector productivity developments.