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Benefits and perils of internal (wage) devaluation

A joint research by Jörg Decressin and Prakash Loungani of the International Monetary Fund (IMF) examines the effectiveness of internal devaluation within the eurozone. Their findings suggest that in times of crisis it is more challenging to fully reap the benefits of internal devaluation as all members of a monetary union would try to pursue the same policy action

STEFANO FRANCESCO FUGAZZI reports. Extract from abceconomics-news-nr2-0116

Internal devaluation – a set of policy actions that tries to replicate the outcomes of an external (currency) devaluation – has featured among the policies suggested for Eurozone countries with large external deficits during the global crisis. At the onset of the crisis, foreign capital fled some of these countries, putting them in financial trouble. But, as members of a currency union, the option of devaluation to restore competitiveness was not open to them.

Faced with a crisis and unable to devaluate the currencies, Eurozone countries can pursuit either a significant fiscal adjustment or wage moderation. A recent IMF research led by Jörg Decressin investigated the impact of the latter.

In order to quantify the effects of wage moderation, the economists simulated the effects of a 2% contraction in wage (and price) inflation on 11 Eurozone member states, including five economies that suffered large capital flight. This is what they found out:

1) In the case of a country-specific crisis, if the sole affected economy undertakes wage moderation, the net effect on output – that is gross domestic product (GDP) – is positive both for that economy as well as for the entire Eurozone.

2) If the crisis affects more countries simultaneously and if all affected countries undertake wage moderation together, their output still expands, albeit to a lesser degree.

3) If the central bank is able to cut policy interest rates, output also expands in the entire Eurozone. This is because the central bank is able to offset the adverse impact of wage moderation by some countries on the output of other countries by lowering policy interest rates. This in turn lowers long term interest rates in these countries, boosting investment and consumption of durables.

4) When interest rates hit the zero lower bound, that is when the short-term nominal interest rate is at or near zero, if central banks undertake unconventional measures such as quantitative easing which mime a 50 basis points reduction, then output in the crisis-hit countries as well as the Eurozone as a whole rises modestly in response to wage moderation.

5) The research also shows that wage moderation could increase income inequality. If wage moderation does not fully pass through to lower domestic prices, real product wages fall and profits rise, implying a shift in the distribution of income from workers toward capital owners.



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