## _sdn1522 — WAGE MODERATION IN EUROPE (EXECUTIVE SUMMARY & SELECTED CHAPTERS)

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### Overview and purpose
- Short-run economic impact of wage moderation and policy implications in the euro area, with focus on monetary policy and the zero lower bound (ZLB).
- Uses IMF’s Flexible System of Global Models (FSGM) via the EUROMOD module to explore channels and spillovers across multiple euro area economies.
- Focuses on labor-based internal devaluation (incomes policy), not product or fiscal measures.

### Key illustrative policy shock
- Coordinated, exogenous reduction in nominal wage growth by 2 percentage points (incomes policy), modeled as a negative cost-push shock to the wage Phillips curve:
  - Timing: 1 percentage point reduction in year 1 and an additional 1 percentage point in year 2; thereafter nominal wage growth returns gradually toward baseline, implying a permanent decline in the nominal wage level relative to baseline.
- Alternative monetary accommodation scenario:
  - Quantified QE modeled as a 50 basis point reduction in the aggregate term premium on long-term interest rates.

### Main simulation results (quantitative findings)
- Single crisis-hit economy (average across crisis-hit economies) moderates wages by 2 percentage points:
  - Real GDP level: about 1 percent above baseline by year 2 and almost 2 percent above baseline by year 3 (much of the benefit from a rise in exports).
- All crisis-hit economies (roughly one-third of euro area GDP) moderate wage growth by 2 percentage points:
  - Real GDP level: about 1 percent expansion by year 3 (about half the expansion of the single-country case).
- All euro area economies moderate wage and price growth by 2 percentage points:
  - Result: loss in output of about 1 percent by year 3.
- Spillovers to euro-area partner countries when all crisis-hit economies moderate:
  - Partner countries’ output contracts by about 1¼ percent relative to baseline by year 3.
  - Net effect on the euro area as a whole is modestly negative: contraction of about ½ percent relative to baseline by year 3.
- Global spillovers:
  - Rest of the world output in year 2 lower than baseline by nearly 0.05 percent in the baseline ZLB scenario.
- Monetary-policy rule of thumb from model:
  - A 100 basis points increase in interest rates sustained for a year lowers GDP by 0.3 percent relative to baseline; simulations feature an increase of 60 basis points that is more persistent.

### Channels through which wage moderation affects activity
- External competitiveness:
  - Lower nominal wage growth → lower domestic prices relative to trading partners → real exchange rate depreciation (when nominal exchange rates unavailable).
  - Competitiveness gains depend on how many economies moderate wages simultaneously and pass-through from wages to prices.
- Firms’ costs, markups, and pass-through:
  - Constant-markup assumption (main simulations):
    - Firms pass lower wages fully into lower domestic prices.
    - Real product wages fixed; no redistribution from labor to capital in main case.
  - Rising-markup alternative:
    - Real product wages fall; income redistributed from labor to capital.
    - Firms’ profitability rises; real market interest rate falls, boosting investment but muting competitiveness gains.
  - Empirical observation: pass-through from wages to domestic prices during the crisis has been less than one.
- Real interest rates, debt, and domestic demand:
  - Wage moderation reduces inflation; if nominal policy rates are constrained by the ZLB, real interest rates rise, raising real public and private debt burdens and suppressing consumption and investment.
- Pricing in foreign markets:
  - If firms maintain foreign-market pricing, foreign demand need not increase immediately; improved exporter profits should eventually raise investment and tradable supply.
- Labor market supply and structural reforms:
  - Structural labor market reforms lower natural unemployment or raise participation; they affect medium-run potential output and are distinct from incomes policy.

### Role of the zero lower bound (ZLB) and monetary accommodation
- ZLB binding (baseline): nominal policy rates cannot fall in response to lower inflation → real interest rates rise → negative demand effects in partner countries and weaker euro-area aggregate outcomes.
- When ZLB is not binding: central bank can reduce policy rates in response to disinflation → real interest rates broadly flat and output expands.
- QE scenario (50 basis point term premium reduction):
  - Boosts output in crisis-hit economies by more than [1] percent relative to baseline within two years and nearly [1½] percent within three years in the simulations.
  - Small positive effect on euro area as a whole; 50 basis points not large enough to lift partner economies above baseline without additional measures.
  - QE raises euro-area domestic demand and imports, and leads to euro depreciation, redistributing demand to the euro area.

### Fiscal policy interaction and calibration
- Benchmark fiscal reaction: fiscal balance rises by 0.2 percentage point of GDP for every percentage point rise in government debt.
- Alternative (more accommodative) fiscal calibration:
  - Fiscal balances fall by 0.4–0.5 percent of GDP for each percentage point fall in output and fiscal balances rise by 0.05 percentage point for each percentage point rise in the debt-to-GDP ratio.
- Tighter fiscal policy in response to higher debt can dampen output; choice of fiscal instrument matters (general transfers vs. government investment).

### Sensitivities and distributional/financial considerations
- Pass-through sensitivity:
  - A smaller pass-through from wages to domestic prices substantially reduces the negative effect on investment.
- Household liquidity constraints:
  - With 70 percent liquidity-constrained households (vs. 35 percent), the positive effect of wage moderation on crisis-hit economies is smaller and negative spillovers on partner countries and the euro area are larger.
- Financial frictions:
  - Repairing the monetary transmission channel (bank balance sheets, banking union, reduce fragmentation) improves outcomes by lowering risk premiums and amplifying demand effects.
- Income distribution:
  - Wage moderation that does not pass through to prices can increase income inequality (real product wages fall while profits rise), with ambiguous effects on aggregate demand.

### Structural reforms (G20 Comprehensive Growth Strategy examples) and interactions
- Reforms modeled include product market reforms, R&D, employment-protection reform, tax reforms, active labor market policies, childcare/maternity, pension reforms, and infrastructure.
- Combined with wage moderation and QE, simulated effects (black lines in figures):
  - Crisis-hit economies: about [1½] percent higher within 2 years and 2½ percent higher within 3 years.
  - Euro area partners: ¼ percent higher in 2 years and ½ percent higher in 3 years.
- TFP-raising reforms vs. labor-supply reforms:
  - Both raise consumption and investment; TFP reforms produce stronger short-run gains in consumption and investment.
  - TFP reforms have positive spillovers; labor-supply (employment-raising) reforms have negative short-run spillovers in simulations.
- Caveat: simulations assume reforms are fully credible and quickly affect investment; reallocation costs and implementation lags are not accounted for.

### Trade and model parameter values (selected exact figures preserved)
- Import elasticity (activity) for crisis countries:
  - Greece 1.40; Italy 1.10; Ireland 0.88; Portugal 1.10; Spain 1.40.
- Import relative price elasticity for crisis countries:
  - Greece –0.75; Italy –0.64; Ireland –0.96; Portugal –0.48; Spain –0.75.
- Partner countries (import activity ; relative price elasticity):
  - Austria 0.98 ; –0.64; Belgium 0.70 ; –0.64; Finland 1.05 ; –0.75; France 1.29 ; –0.64; Germany 1.05 ; –0.75; Netherlands 0.90 ; –0.85.
- Representative import weights (Crisis Countries / Partner Countries / Rest of the World), selected:
  - Greece 0.17 / 0.33 / 0.50; Italy 0.07 / 0.41 / 0.52; Ireland 0.04 / 0.21 / 0.75; Portugal 0.43 / 0.33 / 0.25; Spain 0.13 / 0.36 / 0.50.
- Export weights (Crisis / Partner / Rest of the World), selected:
  - Greece 0.12 / 0.23 / 0.66; Italy 0.07 / 0.33 / 0.60; Ireland 0.07 / 0.31 / 0.62; Portugal 0.29 / 0.36 / 0.34; Spain 0.16 / 0.36 / 0.47.
- Trade weights in price of foreign markets equation (Crisis / Partner / Rest of the World), selected:
  - Greece 0.09 / 0.25 / 0.66; Italy 0.05 / 0.25 / 0.70; Ireland 0.07 / 0.23 / 0.71; Portugal 0.09 / 0.26 / 0.65; Spain 0.07 / 0.26 / 0.67.

### Policy implications and recommendations (strategic lessons)
- Monetary policy:
  - Crucial to mitigate negative spillovers of wage moderation on partner economies, especially when the ZLB binds.
  - Accommodative monetary policy, including QE that reduces term premia, can modestly offset contractionary effects and support output gains.
- Structural reforms:
  - Growth-enhancing structural reforms, particularly TFP-raising reforms, complement wage moderation and increase output further when credible and implemented alongside supportive monetary policy.
- Fiscal policy:
  - Fiscal easing in countries with policy space can reinforce demand; fiscal reaction functions and choice of instruments matter.
- Coordination and sequencing:
  - Wage moderation is more effective when undertaken by a single or a few crisis-hit economies rather than simultaneously by many economies.
  - An explicit, coordinated incomes policy would need to be accompanied by actions to lower funding costs and by structural reforms to maximize benefits and limit spillovers.
  - A more sensible cross-euro-area proposition: wage moderation in crisis-hit economies combined with wage increases in economies with large current account surpluses.

*Source: IMF staff analysis in "WAGE MODERATION IN EUROPE" (SDN chapter and Executive Summary).*

### EXECUTIVE SUMMARY ___________________________________________________________________________ 4

### WAGE MODERATION IN EUROPE — EXECUTIVE SUMMARY

### Overview and purpose
- Discusses short-run economic impact of wage moderation and policy implications in the euro area, with focus on monetary policy and the zero lower bound (ZLB).
- Uses a coherent, multi-country framework (IMF’s Flexible System of Global Models) to explore channels through which wage moderation affects output and spillovers.
- Focuses on labor as the mechanism of internal devaluation (incomes policy), not on product or fiscal measures.

### Context and motivation
- Several euro area deficit economies experienced a “sudden stop” of private capital flows; examples include Greece, Ireland, Portugal, and Spain.
- Core banks and investors in economies such as Germany, France, and the Netherlands withdrew funds, contributing to liquidity drying up.
- In a currency union (e.g., the euro area) nominal exchange rate depreciation is not available; internal devaluation via lower nominal wage growth and lower inflation or higher productivity relative to trading partners is required to rebuild competitiveness.

### Key findings (simulations and empirical observations)
- Nominal wage growth has moderated sharply, but wages have not fallen relative to precrisis levels in most euro area crisis-hit economies; additional relative price adjustment is needed over the medium run.
- A coordinated, exogenous 2 percent reduction in wage (and price) inflation is used as the illustrative incomes policy in simulations.
- If a single euro area crisis-hit economy undertakes wage moderation:
  - The net effect on output is positive for that economy and for the entire euro area.
- If all crisis-hit economies (which account for some 30 percent of the euro area total GDP) undertake wage moderation together:
  - Their output still expands in the short run, but to a lesser degree than the single-country case.
- The role of the ZLB:
  - If monetary policy is unconstrained by the ZLB (as in the precrisis period), wage moderation expands output in the entire euro area.
  - When the ZLB binds, the negative spillover effect of wage moderation in crisis-hit economies on output in other economies cannot be offset by a cut in interest rates; unless other actions lower agents’ funding costs, euro area-wide output contracts in the short run.
- Quantified policy experiments:
  - Simulated quantitative easing that gets around the ZLB is modeled as a 50 basis point reduction in the aggregate term premium.
  - If monetary policy responds with such QE, output in the crisis-hit economies and the euro area as a whole rises modestly in the short run in response to wage moderation.
  - If, in addition, European Union economies implement the structural reforms committed to under the G20 initiative launched by Australia in 2014, output increases further.

### Channels through which wage moderation affects short-run activity
- External competitiveness:
  - Wage moderation lowers domestic prices relative to trading partners and implies a real exchange rate depreciation when nominal exchange rate adjustment is unavailable.
  - Competitiveness gains depend critically on how many economies pursue wage moderation simultaneously and on the extent to which lower wages translate into lower prices.
- Firms’ costs, markups, and pass-through:
  - In standard New Keynesian frameworks with monopolistic competition and price markups, lower wages tend to translate into lower prices, but outcomes differ by pricing behavior:
    - With a constant markup:
      - Nominal wages do not fall relative to prices of domestic goods but fall relative to prices of imported goods.
      - Real consumption wages decline, while real product wages stay constant.
      - There is no redistribution from labor to capital.
      - The drop in nominal labor income and profits can increase real interest rates and the real debt burden, detracting from domestic demand.
    - When firms raise the markup:
      - Nominal wages fall relative to prices of domestic goods and real product wages fall.
      - There is redistribution of income from labor to capital.
      - Real debt burdens rise and reduce domestic demand but less so than in the constant-markup scenario.
  - During the crisis, pass-through from wages to domestic prices has been less than one.
- Pricing in foreign markets:
  - If firms do not change pricing behavior in foreign markets, foreign demand need not increase; however, better exporter profits should eventually increase investment and tradable supply.
- Real interest rates, debt, and domestic demand:
  - Lower nominal wage growth and lower inflation (or deflation) can suppress domestic demand and increase the real burden of debt, which works against the competitiveness-driven export gains.
- Labor market supply and structural reforms:
  - Structural labor market reforms aimed at lowering natural unemployment or raising labor force participation are emphasized in IMF programs; these affect medium-run employment and potential output but are distinct from an incomes policy.

### Policy implications and recommendations
- Monetary policy is crucial to mitigate negative spillovers of wage moderation on partner economies, especially when the ZLB binds.
- If monetary policy can lower the aggregate term premium (modeled as a 50 basis point reduction), QE can modestly offset contractionary effects and support output gains from wage moderation.
- Growth-enhancing structural reforms (those committed under the G20 initiative) complement wage moderation and increase output further when implemented alongside supportive monetary policy.
- An explicit, coordinated incomes policy (e.g., the simulated coordinated 2 percent slowdown) has not been part of actual programs and would need to be accompanied by actions to lower funding costs and by structural reforms to maximize benefits and limit spillovers.
- Wage moderation pursued alone by multiple economies risks simultaneous relative price adjustments that reduce the competitiveness gains for each participant.

*Source: EXECUTIVE SUMMARY, WAGE MODERATION IN EUROPE (IMF).*

### 13.      Wage moderation may increase real interest rates by reducing inflation. Wage

### 13.      Wage moderation may increase real interest rates by reducing inflation. Wage

### Channels and risks
- Wage moderation can reduce domestic inflation; if nominal interest rates do not adjust commensurately, this implies higher real interest rates and lower consumption and investment.
- This channel is particularly relevant for euro area economies when monetary policy is constrained by the ZLB on nominal interest rates and there is no monetary policy response at the country level.
- With unconstrained monetary policy, the central bank would respond to a fall in inflation by reducing the policy interest rate, stimulating aggregate demand and reducing the value of the domestic currency, which would support competitiveness.
- A reduction in domestic prices can increase government and private debt in real terms and as a ratio to GDP, potentially prompting tighter fiscal policy in countries committed to government debt reduction plans.
- Wage moderation can increase the real burden of household debt and corporate debt, leading to lower consumption and investment if prices do not fall one-for-one with wages.
- Wage moderation could increase income inequality if it does not fully pass through to lower domestic prices; real product wages fall and profits rise, shifting income from workers toward capital owners.
- The overall effect on aggregate demand from distributional shifts is ambiguous: lower consumption from workers (especially lower-income or credit-constrained) versus potentially higher private investment from increased profitability.

### Illustrative model and key assumptions (EUROMOD / FSGM)
- Model: EUROMOD, a module of the IMF’s FSGM; an annual, multi-economy, forward-looking model with micro-founded and reduced-form sectors; contains individual blocks for 11 euro area economies including Greece, Ireland, Italy, Portugal, and Spain (termed “crisis-hit economies”).
- Consumption and investment:
  - Consumption features overlapping generations (OLG)-type households and liquidity-constrained households; households are net lenders.
  - Firms’ investment determined by a Tobin’s q model; firms are net borrowers and risk premiums rise during periods of excess capacity.
- Trade: reduced-form equations as a function of a competitiveness indicator and domestic and foreign demand; competitiveness indicator improves one-for-one with domestic prices (no local-market pricing).
- Potential output: endogenous, modeled by a Cobb-Douglas function with exogenous productivity but endogenous capital and labor supply.
- Inflation: prices and wages modeled by Phillips curve.
- Monetary and fiscal policy: standard reaction functions; endogenous QE not allowed in baseline; government is a net borrower and funding costs determined by policy rate and long-term interest rate.
- Structural model properties:
  - Each economy structurally identical but with different steady-state ratios and behavioral parameters.
  - Baseline simulations assume the ZLB is binding.
- Wage moderation shock (short-term focus):
  - Exogenous reduction in nominal wage growth by 2 percentage points over two years: 1 percentage point in first year, additional 1 percentage point in second year; thereafter nominal wage growth returns gradually toward baseline, implying a permanent decline in the nominal wage level relative to baseline.
  - Modeled as a negative “cost-push” shock to the wage Phillips curve (via wage expectations term).
- Specific modeling assumptions:
  - Firms pass lower wages fully into lower domestic prices (constant markup) in main simulations; real product wages are fixed and there is no redistribution from labor to capital in the main case.
  - No independent monetary policy at the country level and policy rate constrained by the ZLB in baseline. Alternative explored: monetary policy eases via QE that reduces the term premium on long-term interest rates by 50 basis points.
  - Governments tighten fiscal policy in response to an increase in government debt: fiscal balance rises by 0.2 percentage point of GDP for every percentage point rise in government debt (benchmark fiscal reaction).
  - Alternative (more accommodative) fiscal calibration: fiscal balances fall by 0.4–0.5 percent of GDP for each percentage point fall in output and fiscal balances rise by 0.05 percentage point for each percentage point rise in debt-to-GDP ratio.
  - A scenario with a 50 percent pass-through from wages to prices is also noted for sensitivity.

### Main simulation results and quantitative findings
- Two competing short-run effects for crisis-hit economies:
  - Competitiveness effect (positive): contribution of exports to growth rises, supporting consumption and investment.
  - Demand effect (negative): in the first two years real interest rates rise above baseline because nominal rates do not respond to lower inflation (ZLB), moderating consumption and investment.
- Net short-term outcomes depend on how many economies undertake wage moderation:
  - Single crisis-hit economy moderates wages by 2 percentage points (average across crisis-hit economies):
    - Fall in nominal wage inflation boosts level of real GDP by about 1 percent relative to baseline by the second year and almost 2 percent by the third year, with much of the benefit from a rise in exports.
  - All crisis-hit economies (roughly one-third of euro area GDP) moderate wage growth by 2 percentage points:
    - Yields about a 1 percent expansion in output by the third year (about half the expansion of the single-country case).
    - Contribution of net exports to GDP is still positive, while contributions of consumption and investment are initially negative.
    - Exports rise less than in the single-country case, reflecting lower demand from euro area partner countries; real interest rates are somewhat higher than in the single-country case.
    - Government debt-to-GDP ratio rises slightly more, prompting fiscal tightening per the fiscal reaction function.
  - All euro area economies moderate wage and price growth by 2 percentage points:
    - Results in a loss in output by about 1 percent by the third year.
    - Positive competitiveness effect is weak and negative demand effect dominates.
    - Rationale: intra-euro area trade accounts for nearly half of total euro area trade; euro area countries exchange goods and services equivalent to about 20 percent of euro area GDP per year.
- Qualitative observations:
  - The short-term effect of wage moderation on economic activity is larger the fewer economies undertake it.
  - A smaller pass-through from wages to domestic prices substantially reduces the negative effect on investment.
  - To the extent that rising output reduces risk premiums, wage moderation leads to a somewhat larger expansion in output as the demand effect is less negative.

### Policy implications and scenarios
- Monetary policy response is crucial in shaping macroeconomic effects of wage moderation:
  - Under the ZLB with no country-level monetary response, wage moderation can raise real interest rates and depress domestic demand.
  - If monetary policy can ease (including QE that reduces term premia by 50 basis points in alternative scenarios), the negative demand effect is mitigated.
- Fiscal policy interaction:
  - Tighter fiscal policy in response to higher real debt burdens can dampen output; choice of fiscal instrument matters (e.g., general transfers versus government investment).
  - More accommodative fiscal reaction functions (weaker debt response and operational automatic stabilizers) generally strengthen domestic demand but do not qualitatively change results.
- Strategic recommendation:
  - Wage moderation is more effective when undertaken by a single (or few) crisis-hit economies rather than across-the-board moderation.
  - A more sensible proposition than wage moderation across all euro area economies is wage moderation in crisis-hit economies combined with wage increases in economies with large current account surpluses.

*WAGE MODERATION IN EUROPE — INTERNATIONAL MONETARY FUND*

### 23.      Wage and price moderation in crisis-hit economies has adverse spillover effects on

### 23.      Wage and price moderation in crisis-hit economies has adverse spillover effects on

### Spillover overview
- When all crisis-hit economies implement wage moderation together:
  - Crisis-hit economies experience a positive effect on output (blue lines in Figure 2 and Figure 1).
  - Output of euro area partners contracts by about 1¼ percent relative to baseline by the third year (blue lines in Figure 3).
  - Net effect on euro area as a whole is modestly negative in the short run: a contraction of about ½ percent relative to baseline by year 3 (blue lines in Figure 4).
- Global spillovers are small but not negligible: in year 2 output in the rest of the world is lower than baseline by nearly 0.05 percent.22

### Channels reducing partner-country GDP (aggregate decline ≈ 1¼ percent by year 3)
- Less demand in crisis-hit economies for goods and services produced by euro area partners:
  - Cyclical effects (less demand for traded durables in recessions) play only a negligible role.
  - Crisis-hit countries import less from partner countries because home-produced goods become cheaper (expenditure switching in import equation); this effect is small.
  - Crisis-hit economies’ expenditure, notably on consumption, declines below baseline through the second year due to decline in households’ real consumption wages (demand effect in import equation); this reduces partner-country GDP by less than ¼ percent.
- Expenditure switching away from partner-country goods:
  - Partner-country agents spend a smaller proportion of incomes on home-produced goods because crisis-hit economies’ goods become cheaper (expenditure switching in import equation); accounts for a ¼ percent decline in GDP.
  - Agents spend a greater share on rest-of-world goods because the euro appreciates as real interest rates rise; accounts for another ¼ percent decline in GDP.
- Higher real interest rates:
  - Reduce consumption, investment, and output in partner economies; accounts for a bit more than a ½ percent decline in partner-country GDP and is the largest negative effect.
  - Explains why partner-country imports drop notwithstanding cheaper foreign goods (real interest rate tightening reduces domestic demand and raises unemployment, triggering further wage and price declines until a new equilibrium).

### Role of the zero lower bound (ZLB)
- The main factor behind the drop in euro area output despite expansion in crisis-hit economies is the ZLB.
- When the ZLB is not binding:
  - Real interest rates are broadly flat and output expands.
  - Relative to the ZLB-binding scenario, real interest rates are about ¾ percentage points lower starting in year 2 and output is 1 percent higher.26

### Monetary policy response and QE (50 basis point term premium reduction)
- Scenario: QE that achieves a 50 basis point reduction in the term premium on long-term interest rates to support activity when policy rates are at the ZLB.
- Effects:
  - Large positive effects on output in crisis-hit economies (Figure 2, red line): boost of more than [1] percent relative to baseline within two years and nearly [1½] percent within three years.
  - Small positive effect on the euro area as a whole (Figure 4, red line).
  - The 50 basis point reduction is not large enough to lift output in euro area partner economies above baseline (Figure 3); a stronger monetary response or fiscal expansion in partner countries with fiscal space could do more.
- Effects on the rest of the world:
  - QE raises euro-area domestic demand and imports from the rest of the world.
  - QE leads to euro depreciation, redistributing demand to the euro area.
  - Foreign central banks may ease in response to appreciating currencies and falling inflation, together resulting in a very modest expansion in output in the rest of the world rather than a modest contraction.

### Sensitivity to financial frictions and liquidity constraints
- Simulations with share of liquidity constrained households at 70 percent rather than 35 percent show:
  - Smaller positive effect of wage moderation on crisis-hit economies.
  - A bit larger negative effect on other euro area economies and on overall euro area output.
- This highlights the usefulness of repairing the monetary transmission channel (bank balance sheets, banking union, reduce fragmentation).

### Rising markups
- Dropping the constant-markup assumption (allowing markups to increase with wage moderation):
  - Real product wages decline; income is redistributed from labor to capital.
  - Firms’ profitability rises and real market interest rate falls, which boosts investment.
  - Smaller decline in domestic prices mutes improvement in external competitiveness; real GDP expands by less than with full pass-through of wage moderation to prices.
  - Spillovers on partner-country GDP are less negative; overall, crisis-hit economies expand less and euro area output falls less.

### Structural reforms (G20 Comprehensive Growth Strategy additions)
- Reforms considered (examples with countries planning initiatives having appreciable impact):
  - Product market reforms (France, Germany, Italy, Spain––TFP).
  - Research and development initiatives (Spain––TFP).
  - Reforming employment protection (France, Germany, Italy, Spain––TFP).
  - Tax reforms (France, Italy––TFP/employment).
  - Active labor market policies and unemployment benefit replacement changes (France, Germany, Italy, Spain––employment).
  - Childcare and maternity programs (France, Germany, Italy––employment).
  - Pension reforms (France––employment).
  - Infrastructure (Germany––GDP).
- Effects when combined with wage moderation and QE:
  - Large positive impact on output everywhere (black lines in Figure 2):
    - Crisis-hit economies: about [1½] percent higher within 2 years and 2½ percent higher in 3 years.
    - Euro area partners: ¼ percent higher in 2 years and ½ percent higher in 3 years (Figure 3).
  - Caveat: simulations assume reforms are fully credible and quickly impact investment; uncertainty exists and reallocation costs are not accounted for.
- TFP-raising reforms vs. labor-supply reforms:
  - TFP reforms raise real wages; labor-supply reforms reduce real wages.
  - Both raise consumption and investment, but in the short run the increase is greater under TFP reforms.
  - Accordingly, TFP reforms have positive spillovers, while labor-supply (employment-raising) reforms have negative short-run spillovers.

### Policy lessons (summary)
- Monetary policy must account for disinflationary impact of wage and price moderation to support a sustainable, broad-based, and positive response of employment and output across the euro area.
- An incomes policy achieving across-the-board wage and price moderation in crisis-hit economies can boost those economies’ output but can produce negative spillovers on their euro area partner economies.
- Short-run determinants of the effects of wage moderation:
  - Wage moderation increases external competitiveness and net exports in crisis-hit economies.
  - Lower wage growth adds to disinflationary pressures, implying higher real interest rates, higher real public and private debt levels, and lower domestic demand.
- Net effects:
  - Wage moderation in crisis-hit economies is net positive for those economies, but effects decrease when all crisis-hit economies moderate wages simultaneously.
  - Under simultaneous moderation, lower demand in crisis-hit economies plus lower competitiveness in partner economies can make partner output fall below baseline.
  - Result is a small negative effect for the euro area as a whole, mainly because monetary policy cannot ease in response to lower inflation when policy rate is at the ZLB.

*Source: IMF staff analysis in "WAGE MODERATION IN EUROPE" (SDN chapter 23).*

### 35.      IMF staff has consistently advocated an accommodative monetary policy in response

### 35.      IMF staff has consistently advocated an accommodative monetary policy in response

### Key findings from simulations
- IMF staff simulations focus on wage moderation and QE and show that together these policies would have positive effects for not only the crisis-hit economies but also their euro area partner countries.  
- The result is a positive effect on output in the euro area as a whole.  
- Structural reforms that boost TFP have a stronger, supportive effect on consumption and investment in the short run than reforms that boost labor supply.  
- The results are consistent with unconventional monetary support (and other measures to help reverse financial fragmentation) underway and the calls for further structural reforms, notably measures that boost productivity.

### Aggregate simulated impacts (summary points)
- Spillovers reduce GDP in partner countries by 1¼ percent by year 3 relative to baseline (as illustrated in Figure 5 in the main text).  
- A rule of thumb from this type of DSGE model: a 100 basis points increase in interest rates sustained for a year lowers GDP by 0.3 percent relative to baseline. In the simulations, there is an increase of 60 basis points, but it is much more persistent.

### Channels and quantitative contributions to partner-country GDP decline
- 1) Demand reduction in crisis-hit economies (imports fall)  
  - This effect on euro partner country GDP is about ¼ percent of GDP.  
  - Depends on: import elasticity with respect to activity for crisis economies (ranges from 0.9 to 1.4) and the share of crisis-hit countries' imports from partner countries (ranges from 0.2 to 0.4).
- 2) Expenditure switching and greater spending on the rest of the world  
  - Expenditure switching (home goods less demanded because crisis economies become cheaper) accounts for a ¼ percent decline in partner GDP.  
  - This depends on the relative price elasticity of imports in partner countries (ranges from –0.6 to –0.9) and the share of partner country imports from crisis countries (about 10 percent).  
  - Appreciation of the euro raises spending on the rest of the world and accounts for another ¼ percent decline in partner GDP. About 60 percent of partner country imports are from the rest of the world.
- 3) Higher real interest rates in partner economies  
  - This trend accounts for a bit more than a ½ percent decline in partner country GDP.

### Policy implications and recommended mix
- Combine accommodative monetary policy (including QE) with structural reforms and fiscal easing in countries with room for policy maneuver.  
- Structural reforms that boost TFP are particularly effective at supporting consumption and investment in the short run versus reforms that mainly boost labor supply.  
- Unconventional monetary support and measures to reverse financial fragmentation, together with national measures and euro-area level policies (e.g., fuller banking union with appropriate common backstops; and further unconventional monetary policy measures), could have substantial positive effects on output in the euro area and beyond.

### Model used: EUROMOD (structure and features)
- Model composition: 24 blocks (11 major euro area countries plus 13 other blocks).  
  - 11 euro area countries: Austria, Belgium, Finland, France, Germany, Greece, Ireland, Italy, the Netherlands, Portugal, and Spain.  
  - 7 other countries: China, India, Japan, Sweden, Switzerland, the United Kingdom, and the United States.  
  - 6 regions: Newly Industrialized Asia excluding China and India, Other European Union, Latin America, Other Advanced Economies, Oil Exporters, and the Rest of the World.
- Model design: semi-structural DSGE with some micro-founded elements (private consumption and investment) and reduced-form representations (trade, labor supply, inflation).  
- Aggregate demand:  
  - Private consumption: two household types—OLG (can accumulate wealth) and LIQ (consume out of current labor income and transfers).  
  - Private investment: Tobin's q with quadratic real adjustment costs; investment negatively correlated with real interest rates.  
  - Public absorption: government consumption and investment are exogenous choices; government investment cumulates into public capital, raising productivity permanently when increased.  
  - Net exports: determined by real competitiveness index (RCI) and reduced-form export/import equations (exports increase with foreign activity and RCI depreciation; imports increase with domestic activity and REER appreciation).
- Aggregate supply: potential output based on Cobb-Douglas technology with trend TFP, steady-state labor force, NAIRU, and actual capital stock.  
- Monetary and fiscal policy: interest rate reaction function (inflation-forecast-based rule), 10-year rate based on expectations theory plus term premium, interest rates on assets are weighted averages of 1-year and 10-year rates; fiscal authority targets long-run debt-to-GDP with instruments including VAT, labor income taxes, corporate taxes, and lump-sum transfers (transfer adjustments maintain public debt-to-GDP under the standard fiscal reaction function).  
- Wages and prices: CPIX determined by a hybrid New Keynesian Phillips curve with country-specific forward-looking behavior; nominal wage Phillips curve with wage stickiness allowing gradual real-wage return to equilibrium.

### Key model parameters and trade elasticities (selected exact values)
- Import elasticity (activity) for crisis countries: Greece 1.40; Italy 1.10; Ireland 0.88; Portugal 1.10; Spain 1.40.  
- Import relative price elasticity for crisis countries: Greece –0.75; Italy –0.64; Ireland –0.96; Portugal –0.48; Spain –0.75.  
- Partner countries (import activity ; relative price elasticity): Austria 0.98 ; –0.64; Belgium 0.70 ; –0.64; Finland 1.05 ; –0.75; France 1.29 ; –0.64; Germany 1.05 ; –0.75; Netherlands 0.90 ; –0.85.
- Representative import weights (share of imports from Crisis Countries / Partner Countries / Rest of the World):  
  - Greece 0.17 / 0.33 / 0.50  
  - Italy 0.07 / 0.41 / 0.52  
  - Ireland 0.04 / 0.21 / 0.75  
  - Portugal 0.43 / 0.33 / 0.25  
  - Spain 0.13 / 0.36 / 0.50  
  - Austria 0.09 / 0.48 / 0.43  
  - Belgium 0.11 / 0.43 / 0.46  
  - Finland 0.06 / 0.33 / 0.60  
  - France 0.17 / 0.34 / 0.49  
  - Germany 0.11 / 0.26 / 0.63  
  - Netherlands 0.07 / 0.37 / 0.56
- Export weights (Crisis / Partner / Rest of the World):  
  - Greece 0.12 / 0.23 / 0.66  
  - Italy 0.07 / 0.33 / 0.60  
  - Ireland 0.07 / 0.31 / 0.62  
  - Portugal 0.29 / 0.36 / 0.34  
  - Spain 0.16 / 0.36 / 0.47  
  - Austria 0.10 / 0.38 / 0.52  
  - Belgium 0.09 / 0.48 / 0.43  
  - Finland 0.05 / 0.21 / 0.74  
  - France 0.17 / 0.29 / 0.53  
  - Germany 0.11 / 0.26 / 0.63  
  - Netherlands 0.10 / 0.46 / 0.44
- Trade weights in price of foreign markets equation (Crisis / Partner / Rest of the World):  
  - Greece 0.09 / 0.25 / 0.66  
  - Italy 0.05 / 0.25 / 0.70  
  - Ireland 0.07 / 0.23 / 0.71  
  - Portugal 0.09 / 0.26 / 0.65  
  - Spain 0.07 / 0.26 / 0.67  
  - Austria 0.10 / 0.22 / 0.68  
  - Belgium 0.11 / 0.21 / 0.69  
  - Finland 0.08 / 0.22 / 0.71  
  - France 0.09 / 0.18 / 0.73  
  - Germany 0.11 / 0.12 / 0.76  
  - Netherlands 0.11 / 0.25 / 0.64

### Comparative effects of reform types (calibration note)
- TFP reform versus labor supply reform calibrated to yield a 1 percent expansion in real GDP over the long run; simulations indicate TFP reforms produce stronger short-run gains in consumption and investment than labor supply reforms.

*Source: IMF European and Research Departments (WAGE MODERATION IN EUROPE).*

### References

### _sdn1522 - References

### Models, Macroeconomic Frameworks, and Technical Reports
- Andrle, Michal, Patrick Blagrave, Pedro Espaillat, Keiko Honjo, Benjamin Hunt, Mika Kortelainen, René Lalonde, Douglas Laxton, Eleonora Mavroeidi, Dirk Muir, and Susanna Mursula. 2014. “The Flexible System of Global Models–FSGM.” IMF Working Paper 15/64, International Monetary Fund, Washington.
- Blagrave, Patrick, Claudia Godbout, and René Lalonde. Forthcoming. “GMUSE: The Bank of Canada Projection Model for the Global Economy.” Bank of Canada Technical Report, Ottawa.
- Brayton, Flint, and Peter Tinsley, eds. 1996. “A Guide to FRB/US: A Macroeconomic Model of the United States.” FEDS Working Paper 1996-42, Federal Reserve Board, Washington.
- Girouard, Nathalie, and Christophe André. 2005. “Measuring Cyclically Adjusted Budget Balances for OECD Countries.” OECD Economics Department Working Paper 434, Organisation for Economic Co-operation and Development, Paris.

### Fiscal Policy, Public Debt, and Adjustment
- Baldi, Guido, and Karsten Staehr. 2013. “The European Debt Crisis and Fiscal Reaction Functions in Europe 2000–2012.” Discussion Paper, German Institute for Economic Research, Berlin.
- Bohn, Henning. 1998. “The Behavior of U.S. Public Debt and Deficits.” The Quarterly Journal of Economics 113 (3): 949–63.
- Decressin, Jörg, Petya Koeva Brooks, Thierry Tressel, Shengzu Wang, Joong Shik Kang, and Jay Shambaugh. 2014. “Adjustment in Euro Area Deficit Countries: Progress, Challenges, and Policies,” IMF Staff Discussion Note 14/7, International Monetary Fund, Washington.
- International Monetary Fund (IMF). 2010. “Will it Hurt? The Macroeconomic Effects of Fiscal Consolidation.” Chapter 3 in World Economic Outlook, Washington, October.
- Merler, Silvia, and Jean Pisani-Ferry. 2012. “Sudden Stops in the Euro Area.” Bruegel Policy Contribution Issue 2012/06.

### Labor Markets, Wages, and Wage Moderation
- Bean, Charles. 1998. “The Interaction of Aggregate-Demand Policies and Labour Market Reform.” Swedish Economic Policy Review 5(2): 352–83.
- Charpe, Matthieu, and Stefan Kühn. 2015. “Beggar or Prosper-Thy-Neighbour? The International Spillovers of Labour Cost.” ILO Research Paper No. 11, International Labor Organization, Geneva.
- Dao, Mai Chi. 2013. “Foreign Labor Costs and Domestic Employment: What are the Spillovers?” Journal of International Economics 89 (1): 154–71.
- International Labor Organization (ILO). 2013. Global Wage Report 2012/13: Wages and Equitable Growth. Geneva: International Labor Office.
- Kumhof, Michael, Romain Ranciere, and Pablo Winant. Forthcoming. “Inequality, Leverage and Crises: The Case of Endogenous Default.” American Economic Review.

### Monetary Policy, ZLB, and Unconventional Measures
- Chung, Hess, Jean-Philippe Laforte, David Reifschneider, and John C. Williams. 2012. “Have We Underestimated the Likelihood and Severity of Zero Lower Bound Events?” Journal of Money, Credit and Banking, 44 (S1): 47–82.
- Eggertsson, Gauti, and Paul Krugman. 2012. “Debt, Deleveraging, and the Liquidity Trap: a Fisher-Minsky-Koo Approach.” The Quarterly Journal of Economics 127 (3): 1469–513.
- Galí, Jordi. 2008. Monetary Policy, Inflation, and the Business Cycle: An Introduction to the New Keynesian Framework. Princeton: Princeton University Press.
- Galí, Jordi. 2012. “Notes for a New Guide to Keynes (I): Wages, Aggregate Demand, and Employment.” NBER Working Paper 18651.
- Galí, Jordi, and Tommaso Monacelli. 2013, “Understanding the Gains from Wage Flexibility: The Exchange Rate Connection.” Barcelona GSE Working Paper 746, Barcelona Graduate School of Economics, Barcelona.
- International Monetary Fund (IMF). 2013b. “Unconventional Monetary Policies—Recent Experience and Prospects.” IMF Background Paper. Washington.

### Euro Area, Spillovers, and Policy Assessments
- Blanchard, Olivier, Christopher J. Erceg, and Jesper Lindé. 2015. "Jump Starting the Euro Area Recovery: Would a Rise in Core Fiscal Spending Help the Periphery?" NBER Working Paper 21426, National Bureau of Economic Research, Cambridge, Massachusetts.
- Decressin, Jörg, et al. 2014. “Adjustment in Euro Area Deficit Countries: Progress, Challenges, and Policies,” IMF Staff Discussion Note 14/7, International Monetary Fund, Washington.
- European Central Bank (ECB). 2013. (January) Monthly Bulletin 59–74.
- International Monetary Fund (IMF). 2013a. “Euro Area Policies: 2013 Article IV Consultation.” IMF Country Report 13/231, Washington.
- International Monetary Fund (IMF). 2013c. “2013 Spillover Report.” Washington.
- International Monetary Fund (IMF). 2014. Jobs and Growth: Supporting the European Recovery. Washington.
- International Monetary Fund (IMF). 2015a. “Germany: Selected Issues.” IMF Country Report 15/188, Washington.
- International Monetary Fund (IMF). 2015b. “Euro Area Policies––Staff Report.” IMF Country Report 15/204, Washington.
- Schindler, Martin, Helge Berger, Bas Bakker, and Antonio Spilimbergo, eds. 2014. Jobs and Growth: Supporting the European Recovery. Washington: International Monetary Fund.

### Other Relevant Studies and Contributions
- Bordon, Anna, Christian Ebeke, and Kazuko Shirono. Forthcoming. “When Do Structural Reforms Work? On the Role of the Business Cycle and Macroeconomic Policy.” IMF Working Paper International Monetary Fund, Washington.
- Girouard, Nathalie, and Christophe André. 2005. “Measuring Cyclically Adjusted Budget Balances for OECD Countries.” OECD Economics Department Working Paper 434, Organisation for Economic Co-operation and Development, Paris.

*Reference list as provided in the source document.*

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