The Effects of Factor Market Integration on the Macroeconomic Development in Unified Germany

German reunification provides a unique quasi-natural experiment to study the integration of two economies with perfect factor mobility. The reallocation of capital and labor is the most striking characteristic of German unification and will affect the macroeconomic development in East and West Germany in the long run. I therefore propose a baseline three-region decentralized open economy model to study the integration of two economies with perfect factor mobility. Adjustment costs in moving production factors determine the speed of convergence and affect the long run endowment of factor inputs. An extension of the baseline model includes wage-setting behavior as well as tax and transfer policies to consider the specific German case in the early 1990s, when East German wage rates predominated labor productivity and social transfer payments were increased to prevent mass migration. The numerical results reveal that the extended model is capable to reproduce observed income convergence and migration pattern in unified Germany. Moreover, wage-setting behavior and transfer policies decrease the speed of income convergence during the early years.