Does Austerity Go Along with Internal Devaluations?

"Does Austerity Go Along with Internal Devaluations?"

Abstract

We empirically show that the austerity packages implemented in some euro area countries during 2010–2014 were only partially successful in generating internal devaluations. Countries that cut spending indeed experienced a decline in nominal wages, a real exchange rate depreciation, a fall in the relative price of non-tradables and a shift of consumption toward non-tradables, whereas we find no such evidence for countries raising consumption taxes. We show that this asymmetric response is in line with a small open economy model with GHH preferences. Moreover, the output costs of correcting current accounts were higher than anticipated because neither policy was successful in raising exports through lower prices. Instead, current account improvements were solely driven by lower imports stemming from faltering domestic demand. We provide evidence that exporters absorbed lower wages through higher markups, and show in a model with pricing to market that, had firms kept their markups constant, output costs of correcting current account imbalances would have been cut by almost one half.