The Tale of Two Economies: Inflationary Dynamics in the Euro Area and the US in the Context of Uncertainty

Abstract

In recent years, the global economy has been hit by a sequence of severe shocks that affected the two largest economies, the USA and the Euro Area, severely. Uncertainties about the future abound. While the challenges are similar for both economies and the policy tools resemble each other, they apply to different economic landscapes. What can they learn from each other? This paper looks at the basic structural facts, the nature of uncertainty shocks, and the efficiency of policy tools in the two economies. The key to understanding recent developments is uncertainty. This paper argues that the channel through which uncertainty influences inflation, wage cost, and unemployment is the markup firms charge to cover their cost of capital. While the measurements of uncertainty are uncertain, adding a proxy for uncertainty can improve the estimates of the basic New Keynesian model. The Federal Reserve Bank has been more successful because it operates in a more integrated capital market. In the Euro Area, uncertainty is higher than in the US and this could make disinflation in Europe more painful in terms of unemployment.