DP11015 Deleveraging, deflation and depreciation in the euro area

Author(s): Dmitry Kuvshinov, Gernot Müller, Martin Wolf
Publication Date: December 2015
Keyword(s): currency union, deflationary spillovers, deleveraging, downward wage rigidity, paradox of flexibility, real exchange rate, zero lower bound
JEL(s): E42, F41
Programme Areas: International Macroeconomics and Finance
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=11015

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.