Wage Divergence, Business Cycle Co-Movement and the Currency Union Effect

This paper studies the impact of wage growth divergence on business cycle co-movement in the context of currency unions. While the theoretical literature on optimum currency areas highlights the equilibrating effect of divergent wage growth after asymmetric exogenous demand shocks via the external demand channel, recent literature on euro area imbalances emphasizes its dis-equilibrating effect as a source of asymmetric domestic demand shocks, and therefore suggests a negative link to business cycle co-movement. Our empirical results reveal that the latter effect has been clearly dominating in the euro area: Wage growth differentials across countries - while of minor importance for non-euro area EU countries with sovereign currencies - significantly reduce business cycle co-movement within the monetary union and thus increase the cost of the common monetary policy. The large magnitude of the effect calls for enhanced co-ordination efforts of wage policies in the euro area.