baseline scenario which goes to 2012, which is based on the premise that countries converge gradually to
their potential production level.4
Effects of a rise in trend productivity
41. The first simulation illustrates the effect of a productivity gain on macroeconomic and budgetary
performance. As many studies have shown there is considerable potential to raise productivity in the euro
area, be it by product and labour market reforms or stronger innovative activity (OECD, 2003 and 2004).
The simulation assumes that the level of trend labour productivity goes up by a cumulated increase of 2%
over eight years. In the simulation, stronger productivity growth leads to a progressive rise in real wages,
which is compatible with lower inflation (Figure 6). This raises internal demand and boosts net exports,
which benefit from an improved competitiveness. Total demand rises somewhat faster than potential output
and the output gap closes more quickly than in the baseline. The budget balance improves in actual and
structural terms by about 1¼ per cent of GDP at the end of the simulation period. This is mainly due to the
lower nominal interest rates and to a lesser extent to improved social accounts. The reduction of the deficit
allows only a small decline in the debt/GDP ratio, because lower inflation lowers nominal GDP growth. 5
Effects of a rise in participation
42. Figure 6 allows a comparison of these first results with a simulation of an increase in labour force
participation. Considerable room for increases also exist in this domain, especially by sharpening incentives
for young and older workers to work and by removing obstacles to participation by females (Burniaux et
al., 2003). In this simulation it is assumed that changes in incentives push up trend participation by 1
percentage point gradually over eight years. As in the earlier case, domestic demand and net exports rise.
The rise in participation leads, however, to some rise in unemployment, which leads to lower real wages
and inflation, which stimulates competitiveness and employment and finally disposable income. Demand is,
however, initially not rising as fast as supply, so that the output gap is higher for some years. The budgetary
situation also improves in this simulation. But it is somewhat smaller than in the earlier simulation, because
unemployment is somewhat higher. Moreover, the debt/GDP ratio remains close to the baseline. The
improvement of the budgetary situation is likely however to be somewhat underestimated. Especially a rise
in the participation of older workers would reduce spending on early retirement, while over the longer term,
unemployment should return to the baseline level.
4. Medium-term scenarios that prolong the short-term projections are regularly up-dated by the OECD. The are based on the premise that the output
gap will close over the scenario’s horizon (by 2012), while unemployment converges to the structural unemployment rate. Commodity prices and
exchange rates are held fixed in real terms, while the oil price declines from $54 at the end of 2007 to $44 per barrel by 2012. Monetary policy
aims at price stability, while fiscal policy remains unchanged, with the primary budget balance virtually stable between 2007 and 2012 in most
countries. Details can be found in the OECD Economic Outlook 78 (2005).
5. The debt profile is determined by the following equations:
Debt (t) = primary balance (t) + debt (t-1)* (1+ r(t))/(1+g(t)) with r(t) being the nominal interest rate at t and g(t) nominal growth of GDP. With
no improvement in the primary budget, lower inflation tends to the growth of nominal GDP, which offsets the effect of lower interest rates. In this
case public debt twill change little with respect to the baseline. If, however, nominal growth decline more than interest rates, a snow-ball effect
will raise indebtedness, even if there is no deterioration in the primary budget balance.
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