European Economy. Economic Papers. Germany's growth performance in the 1990's

3.1.A Annex: The real exchange rate and economic performance in Germany
In the 1990s we observed a real effective appreciation of the DEM, which peaked in the mid-
1990s at around 10%. This sub-section looks at the macroeconomic impact of a competitiveness
shock of this order of magnitude on the German economy. Such an analysis is complicated
since the real exchange rate is not an exogenous variable but is itself the result of specific
shocks. Depending on the type of shock, the macroeconomic outcome of a real appreciation can
be very different. It can be associated with an increase as well as with a decrease in economic
growth. A positive link between growth and appreciation could emerge, for example, if world
demand for domestic goods increases. Another example for a positive link would be
expectations about positive future return differentials in the domestic economy versus the rest of
the world. The US experience in the 1990s is suggestive of such a link. Alternatively a real
exchange rate appreciation could indicate specific demand or cost pressures in the domestic
economy. In this case one would expect a negative effect of the real appreciation on economic
activity. Therefore, an analysis of the impact of real exchange rate movements on the German
economy requires an explicit view on the type of shock that occurred in Germany. It the case of
Germany, both a demand and a cost shock can be identified. The demand shock arises from
expansionary fiscal policy, driven by the need to finance substantial transfers to the New
Länder. The explicit policy of social partners to achieve a rapid convergence of wages in East
Germany to West German levels, constitutes a cost shock. Both shocks are quantified as
follows:
Fiscal shock:
This is identical to the shock discussed in sub-section 2.2. The budget deficit
increases by 3.5% in 1995, despite an increase in effective labour taxes of 4% and an increase in
consumption taxes of 1.5%.
Wage shock
: Within the first two years after re-unification the accumulated difference between
real wage and labour productivity growth in the business sector reached about 4%. This was due
to an explicit policy of social partners to equalise living conditions. These post re-unification
agreements are not captured in the standard wage bargaining rule of the QUEST model. In order
to analyse the impact of these agreements a wage shock is calibrated such that the model
generates an increase of real wages over productivity of 4% in 1992
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and matches the evolution
of the wage share in Germany. From 1993 onwards the policy of rapid real wage convergence
was pursued less vigorously. This is reflected in the simulations by keeping the level of the
wage shock constant from 1993 onwards.