PIIGS in the Euro Area. An Empirical DSGE Model

Abstract

We build up and estimate a two-regions DSGE model of the Euro area, investigating the interactions between the peripheral countries (PIIGS) and the rest of EMU. Our main focus is on the 2008-2009 …nancial crisis and on the subsequent 2010- crisis. One striking result is that both crisis periods have been mainly caused by demand shocks in the core Euro area countries, whereas region-speci…c permanent technology shocks explain most of output growth slowdown in in the PIIGS countries. Our model accounts for shocks that might cause a de facto segmentation between the two regional …nancial markets, but such shocks are unimportant for explaining the EMU business cycle. The model predicts that, absent productivity-enhancing reforms, the accumulated output and productivity gaps between the two regions will persist even when the adverse cyclical conditions are reversed. This has important implications for EMU …scal rules, which should foster convergence and macroeconomic stability. In fact, austerity should be abandoned in favor of accomodating …scal policies that should limit the