EZ internal devaluations: Evidence on negative demand spillovers

Jörg Decressin, Prakash Loungani 02 December 2015



Internal devaluation – a set of policy actions that tries to replicate the outcomes of an external 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.

Farhi et al. (2011) argued that “even when the exchange rate cannot be devalued, a small set of conventional fiscal instruments can robustly replicate the real allocations attained under a nominal exchange rate devaluation.” A similar argument was made by Domingo and Cottani (2010). Another means through which an internal devaluation can occur is through wage moderation (see the discussion in Corsetti 2010).

Can such internal devaluations work? Our recent paper provides an answer for the case of wage moderation (Decressin et al. 2015). Our main take-away is that, if undertaken by several Eurozone countries at the same time, wage moderation can only work well if monetary policy is not constrained by the zero lower bound. If it is constrained, then it can only work if activity can be supported by quantitative easing. In the absence of sufficient monetary accommodation, wage moderation does not deliver much of a boost to output in the countries that are undertaking it and also ends up lowering output in the Eurozone as a whole.

When does wage moderation work?

To quantify the effects of wage moderation, our paper uses a large-scale model of the world economy. The model contains individual blocks for 11 Eurozone economies, including five economies that suffered large capital flight, which we refer to as the ‘crisis-hit’ economies. The model also contains 13 blocks for the rest of the world.

The specific policy considered for simulation purposes is a 2% reduction in wage (and price) inflation. While wage moderation does boost competitiveness and exports, its overall effect on output in the short run is uncertain. The reason is that lower nominal wage growth and lower inflation—or possibly deflation—can suppress domestic demand and increase the real burden of debt. So the competitiveness and aggregate demand effects work in opposite directions.

The model simulations show that whether the competitiveness or demand effects dominate in the short run depends on two important factors:

  • The number of countries that are undertaking wage moderation; and
  • The actions taken by the central bank.

These two factors also play a key role in determining the spillovers from wage moderation, namely, the impact that wage moderation by a country (or a set of countries) has on other countries, in particular on the rest of the Eurozone.

Spillovers from wage moderation

Specifically, the model simulations provide the following results:

  • If a single Eurozone Crisis-hit economy undertakes wage moderation, the net effect on output is positive both for that economy as well as for the entire Eurozone.
  • If all Crisis-hit economies – which account for some 30% of the Eurozone total GDP –undertake wage moderation together, their output still expands, albeit to a lesser degree. 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.

Things change when policy interest rates hit the zero lower bound.  When this happens, the negative spillover effect of wage moderation in the crisis-hit economies on output in the other economies cannot be offset by a cut in interest rates. Unless other actions are taken to lower long term interest rates, Eurozone-wide output contracts in the short run.

Our findings substantiate the theoretical findings in work by Charpe and Kühn (2015). They show, in a two-country model, that the effects of wage moderation on the domestic economy are positive, but that the international spillovers are likely to be negative when the zero lower bound is binding.

The benefits of quantitative easing

The central bank, however, is not out of ammunition when policy interest rates hit zero. It can take actions to directly lower long term interest rates, a policy known as quantitative easing. The model simulations confirm that if the central bank takes actions that result in a 50 basis point reduction in long term interest rates, output in the Crisis-hit economies as well as the Eurozone as a whole rises modestly in response to wage moderation.

The results are illustrated in the Figure 1, which shows the path of Eurozone output (in terms of percentage deviation from baseline). Simultaneous wage moderation by crisis-hit countries lowers Eurozone output but the effect can be offset by quantitative easing.  If, additionally, the EU economies implement the structural reforms that they committed to under the G20 initiative launched by Australia in 2014, output increases further (see Corsetti 2010 on the importance of such reforms for the Eurozone).

Figure 1. Impact on Eurozone output from wage moderation, quantitative easing and structural

Figure 1 shows the impact on Eurozone output over a three year period when:

  • Eurozone crisis-hit economies carry out wage moderation—the response of output is shown by the blue line;
  • The effects of quantitative easing by the central bank are added in—the orange line; and
  • The effects of structural reforms are added to (i) and (ii)—the purple line.

The response of output is shown as percentage deviation from baseline.

Wage moderation and inequality

Though the focus of our work is on the effects on aggregate output, our results also show 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 (see Pisani-Ferry 2013, for a discussion of such incomplete pass-through in Eurozone economies).

The overall effect of these distributional effects on aggregate demand is uncertain. On the one hand, the rise in profitability is likely to spur private investment, particularly if firms are credit constrained and therefore depend on internal cash flow. On the other hand, a shift in the distribution of income from labour to capital implies, other things equal, a reduction in consumption, particularly among lower-income or credit-constrained workers who are likely to have a high marginal propensity to consume. Our model assumes similar marginal propensities to consume across agents; allowing for differences would make it more likely that the distributional effects lower aggregate demand.

Summing up

An internal devaluation that achieves across-the-board wage and price moderation in the Crisis-hit economies can boost their output but can also produce negative spillovers on output of their Eurozone partner economies. The simulation results suggest that the net effects of wage moderation in Crisis-hit economies are positive for their economies, but those effects decrease when all crisis-hit economies moderate their wages at the same time.

  • Under such circumstances—and assuming monetary policy is constrained by the zero lower bound—higher real interest rates and lower domestic demand everywhere in the Eurozone, along with lower competitiveness in the Eurozone partner economies, can mean that overall Eurozone output falls below baseline.

Monetary policy needs to take into account the disinflationary impact of wage and price moderation to support a positive outcome for Eurozone countries’ employment and output.

Authors’ note: The views expressed here are those of the authors and should not be attributed to the IMF, its Executive Board, or its management.


Charpe, M and S Kühn (2015) “Beggar or prosper-thy-neighbour? The international spillovers of labour cost”, ILO Research Paper No. 11, International Labor Organisation, Geneva.

Corsetti, G (2010) “The ‘original sin’ in the Eurozone”, VoxEU.org, 9 May.

Cavallo, D and J Cottani (2010) “For Greece, a ‘fiscal devaluation’ is a better solution than a ‘temporary holiday’ from the Eurozone", VoxEU.org, 22 February.

Farhi, E, G Gopinath and O Itskhoki (2011) “Fiscal devaluations”, NBER, Working Paper No. 17662.

Decressin et al (2015) “Wage moderation in crises: Policy considerations and applications to the Eurozone”, IMF Staff Discussion Note (SDN 15/22), November.  

Pisani-Ferry, J (2013) “Is struggling Europe on the right track?”, Bruegel blog post, February 27. 



Topics:  Competition policy Europe's nations and regions

Tags:  competitiveness, devaluation, internal devaluation, EZ, eurozone, Eurozone crisis, exchange rates, wage moderation, zero lower bound

Senior Advisor, Research Department, IMF

Chief of Development Macroeconomics in the IMF's Research Department