EMU imbalances in a two-country overlapping generations model

The present sovereign debt crisis in the Economic and Monetary Union of the EU (EMU) is partly attributable to the pronounced increase in external imbalances across northern (including central) and southern euro zone countries during the years running up to 2007. While this empirical observation is broadly accepted it remains an open question how the evolution of intra-EMU external imbalances prior to 2007 can be reproduced within an intertemporal general equilibrium model. While Fagan and Gaspar (2008) show in a Yaari (1965)-Blanchard (1985) pure exchange model without public debt how the external imbalances between Northern and Southern EMU countries can be attributed to euro financial integration this paper uses a Diamond (1965)-Buiter (1981) two-country model with production, capital accumulation and public debt to address the open question. Acknowledging the fact that the public debt to GDP ratios of southern and northern euro zone countries did not markedly change up to the Great Recession we find in line with Fagan and Gaspar (2008) that differences in economic fundamentals between northern and southern euro zone countries were transformed into the observed external imbalances when interest rates converged.