Working Paper: CEPR ID: DP11015
Authors: Dmitry Kuvshinov; Gernot Müller; Martin Wolf
Abstract: During the post-crisis period, economic performance has been highly heterogenous across the euro area. While some economies rebounded quickly after the 2009 output collapse, others are undergoing a protracted further decline as part of an extensive deleveraging process. At the same time, inflation has been subdued throughout the whole of the euro area and intra-euro-area exchange rates have hardly moved. We interpret these facts through the lens of a two-country model of a currency union. We find that deleveraging in one country generates deflationary spillovers which cannot be contained by monetary policy, as it becomes constrained by the zero lower bound. As a result, the real exchange rate response becomes muted, and the output collapse---concentrated in the deleveraging economies.
Keywords: currency union; deflationary spillovers; deleveraging; downward wage rigidity; paradox of flexibility; real exchange rate; zero lower bound
JEL Codes: E42; F41
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Deleveraging in one country (F65) | Deflationary pressures in the currency union (E31) |
| Deflationary pressures in the currency union (E31) | Muted real exchange rate response (F31) |
| Deleveraging in one country (F65) | Reduction in aggregate demand (E00) |
| Reduction in aggregate demand (E00) | Downward pressure on prices (D41) |
| Deflationary pressures (E31) | Concentrated output collapse in deleveraging economies (F65) |
| Larger economies experiencing deleveraging shock (F65) | Broader implications for entire currency union (F36) |
| Increasing wage flexibility (J38) | Worsened recession (E65) |
| Deflationary pressures (E31) | Real exchange rate adjustments (F31) |