With the Eurozone nations unable to gain competitive relief via nominal exchange rate adjustments the hope is that by deflating wages and prices real unit labour costs will fall. Assuming other nations do nothing and wages and prices in one nation fall at the same rate, then a real exchange rate depreciation (relative to other nations) requires labour productivity and employment growth to rise.
Answer: False
The answer is False.
The EMU countries cannot improve their international competitiveness by exchange rate depreciation, which is the option always available to a fully sovereign nation issuing its own currency and floating it in foreign exchange markets.
Thus, to improve their international competitiveness, the EMU countries have to engage in "internal devaluation" which means they have to cut real unit labour costs - which are the real cost of producing goods and services. Governments setting out on this policy path have to engineer cuts in the wage and price levels (the latter following the former as unit costs fall).
But the question demonstrates that it takes more than just a nominal deflation. The strategy hinges on whether you can also engineer productivity growth (typically).
Given the assumption (wage and prices falling at the same rate), what happens to employment growth is irrelevant.
Some explanatory notes to accompany the analysis that follows:
The following table models the constant and growing productivity cases but holds employment constant for five periods. We assume that the nominal wage and the price level deflate by 10 per cent per period over Period 2 to 5. In the productivity growth case, we assume it grows by 10 per cent per period over Period 2 to 5.
It is quite clear that under the assumptions employed, RULC cannot fall without productivity growth. The only other way to accomplish this is to ensure that nominal wages fall faster than the price level falls. In the historical debate, this was a major contention between Keynes and Pigou (an economist in the neo-classical tradition who best represented the so-called "British Treasury View" in the 1930s. The Treasury View thought the cure to the Great Depression was to cut the real wage because according to their erroneous logic, unemployment could only occur if the real wage was too high.
Keynes argued that if you tried to cut nominal wages as a way of cutting the real wage (given there is no such thing as a real wage that policy can directly manipulate), firms will be forced by competition to cut prices to because unit labour costs would be lower. He hypothesised that there is no reason not to believe that the rate of deflation in nominal wage and price level would be similar and so the real wage would be constant over the period of the deflation. So that is the operating assumption here.
The following table models the constant and growing productivity cases as above but allows employment to grow by 10 per cent per period. All four scenarios in the Table are them modelled in the following graph with the Real Unit Labour Costs converted into index number form equal to 100 in Period 1. As you can see what happens to employment makes no difference at all.
I could have also modelled employment falling with the same results.
The following graph shows the four scenarios shown in the last two tables. I have dashed some scenarios to make the lines visible (given that Case A and Case C) are equivalent as are Case B and Case D. What you learn is that if wages and prices fall at the same rate and labour productivity does not rise there can be no reduction in unit or real unit labour costs.
So the internal devaluation strategy relies heavily on productivity growth occurring. The literature on organisational psychology and industrial relations is replete of examples where worker morale is an important ingredient in accomplishing productivity growth. In a climate of austerity characteristic of an internal devaluation strategy it is highly likely that productivity will not grow and may even fall over time. Then the internal devaluation strategy is useless.
This graph compares the two scenarios in the first Table with the more realistic one that labour productivity actually falls as the government ravages the economy in pursuit of its internal devaluation. As you can see real unit labour costs rise as labour productivity falls and the economy's competitiveness (given the exchange rate is fixed) falls.
Of-course, this "supply-side" scenario does not take into account the overwhelming reality that for an economy to realise this level of output over an extended period aggregate demand would have to be supportive. The internal devaluation strategy relies heavily on the external sector providing the demand impetus.
Given that Eurozone trade is heavily internal, it seems far fetched to assume that the trade impact arising from any successful internal devaluation will be sufficient to overcome the devastating domestic contraction in demand that will almost certainly occur. This is why commentators are calling for a domestic expansion in Germany to boost aggregate demand throughout the EMU, given the dominance of the German economy in the overall European trade.
That is clearly unlikely to happen given Germany has been engaged in a lengthy process of internal devaluation itself and the Government is resistant to any stimulus packages that might improve things within Germany and beyond via the trade impacts.
The following blogs may be of further interest to you:
That is enough for today!
(c) Copyright 2016 William Mitchell. All Rights Reserved.