## 5. Simulation Results: Investment and Risk Premium Shock

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---

### I. Motivation and Baseline Context
- Since the global financial crisis, growth in output per capita in the euro area has stalled and the gap with the United States has widened.
- In 2014, output per capita in the euro area remained at the same level as in the mid-2000s.
- In PPP terms, nominal GDP per capita in the euro area is nearly $15,000 below that in the United States.
- Potential growth slowed in advanced economies well before the global financial crisis, driven mainly by declining total factor productivity (TFP) growth.
- Potential output estimates for major advanced economies have been revised down dramatically since the crisis.
- Baseline expectation: subdued medium-term growth and inflation, leaving the euro area vulnerable to shocks given high unemployment, public and private indebtedness, and limited policy space.
- Key numeric references from motivation:
  - Output per capita indices use 1991=100 for real output per capita charts.
  - Pre-crisis trend defined as trend growth over 1991-2007.

### II. Diagnosis of Output per Capita: Labor, Capital, and TFP
- Labor
  - Output per capita decomposed as: labor input per capita + capital per capita + total factor productivity.
  - Before the crisis, rising labor force participation and declining unemployment offset a shrinking working-age population (aged 15-64 years).
  - During the crisis, contribution of labor to per-capita growth in the euro area turned negative due to slower rise in labor force participation, working-age population growth slower than total population, and higher unemployment.
  - United States: decline in labor inputs driven by decline in labor force participation, shrinking working-age population, and rising unemployment.
  - Japan: decline in labor inputs driven mainly by shrinking working-age population.
  - Demographics/projections: working-age population growth projected to decline significantly in advanced economies.
  - Euro area labor force expected to expand by 0.3 percent annually over the medium term (WEO, April 2014), about one-third of level during 2002-07.
  - Implication: raising employment growth above pre-crisis levels requires significant reduction in structural unemployment.

- Capital
  - Capital accumulation slowdown accelerated during the crisis.
  - United States saw a larger decline in capital accumulation during the global financial crisis but has since experienced a strong pickup in investment; euro area investment expanded only moderately since H2 2014.
  - Result: capital is growing more slowly than population; particularly sharp decline in countries such as Greece and Italy.
  - Ratio of investment-to-capital (I/K) has fallen significantly since the crisis; based on past financial crises, I/K and capital stock growth are likely to remain below pre-crisis levels for some time.
  - Time to recovery: even where capital per capita growth has partially recovered (e.g., United States), a complete recovery likely to take a decade or more (Hall, 2014).

- Total Factor Productivity (TFP)
  - Labor productivity (output per hour worked) in euro area grew faster than the United States until mid-1990s; since then euro area productivity growth has fallen below U.S. levels until the crisis.
  - TFP growth slowed in most euro area economies; negative TFP growth since early 2000s for Italy, and negative during the crisis for Greece and a few others.
  - Service sector productivity slowdown explains much of the TFP decline, linked to slower adoption and diffusion of ICT.
  - Unlike the United States (where service sector productivity has picked up), euro area service productivity remains well below pre-crisis peaks in countries such as Germany and Italy.
  - Outlook: potential growth rises only slightly from 0.7 percent during 2008-14 to about 1.1 percent during 2015–20, versus 1999–2007 average of 1.9 percent (WEO, April 2015).
  - Slow progress on addressing crisis legacies likely to weigh on aggregate demand.

### III. Crisis Legacies: Unemployment and Deleveraging
- High Unemployment
  - Euro area unemployment remains high: nearly 11 percent in the euro area; 25 percent in Greece.
  - Long-term unemployed share (unemployed > 12 months) continues to increase, raising risks of skill erosion and hysteresis.
  - High youth unemployment risks creating a “lost generation.”
  - Projected NAIRU:
    - Italy: NAIRU projected to remain higher than during the crisis over the medium term.
    - France: NAIRU projected to remain at the crisis level over the medium term.
    - Spain: NAIRU expected to decline significantly from unprecedented levels but remain above 15 percent over the medium term.
  - Recovery illustration: without significant pick-up in growth, it could take around 7 to 10 years for Italy and Spain to reduce unemployment to pre-crisis levels (sensitive to forecast growth and Okun’s coefficient).
  - Policy note: faster implementation of structural reforms and more spending on active labor market policies would help increase employment opportunities, especially for youth.

- High (Private Sector) Debt
  - Non-financial corporate (NFC) debt-to-equity ratios have been falling in most euro area countries, supported by financial surpluses used to pay down debt.
  - Spain and Ireland recorded relatively strong reductions in NFC debt-to-GDP ratios.
  - Spain: NFC debt reduction of nearly 20 percentage points from the peak driven by declining corporate borrowing and debt repayment through asset sales.
  - Deleveraging effects observed: fall in corporate borrowing, investment decline, sharp increase in savings, significant reduction in employment (Spain example).
  - Historical evidence: based on past corporate deleveraging episodes, two-thirds of the increase in debt is subsequently reduced.
    - If euro area deleveraging follows similar path, sizable deleveraging needs remain and present a headwind for investment recovery.
    - Example implication: if accumulated debt were to fall by two-thirds, it would imply a further reduction of nine percentage points of GDP for the euro area as a whole.
  - Household sector: household debt-to-GDP ratios have come down by 10-20 percentage points in high-debt countries but remain significantly above pre-boom levels, risking a prolonged debt overhang that weighs on spending.

### IV. Illustrative Downside Scenario: Design and Modelling
- Baseline: subdued growth and inflation over medium term due to low potential growth, high unemployment, heavy real debt burdens, and weak balance sheets that suppress demand.
- Vulnerability: subdued medium-term prospects make euro area susceptible to negative shocks which, combined with limited policy space, could push the economy into stagnation.
- Policy space constraints:
  - Unconventional monetary policy may have reached limits; policy rate cannot be lowered further below zero.
  - Fiscal space limited overall; short-run fiscal policy constrained to automatic stabilizers and long-run fiscal policy constrained by stabilizing debt-to-GDP ratios.
- Economic dynamics: negative shocks can create self-reinforcing low growth-low inflation equilibria if no further monetary or fiscal support is available.
- Two illustrative simulations (using FSGM; outcomes measured against April 2015 WEO baseline):
  1. Private investment shock.
  2. Private investment shock plus risk premium shock.
- Simulation assumptions:
  - Unconventional monetary policy held at limits (no more unconventional action than in baseline).
  - Policy responses limited to conventional monetary policy and fiscal policy.
  - Due to zero lower bound and limited fiscal space, monetary policy cannot be eased further and fiscal policy cannot provide stimulus beyond automatic stabilizers in the short run.
- Modelling notes:
  - Simulations conducted using the Flexible System of Global Models (FSGM) in coordination with IMF Research Department.
  - FSGM comprises three core models (G20MOD, EUROMOD, EMERGMOD); is semi-structural; trade, labor supply, and inflation are reduced form; supply determined by aggregate Cobb-Douglas production function; monetary and fiscal policies endogenously set with simple rules.
  - Simulations provided by B. Hunt and S. Mursula (IMF); model documentation: Andrle and others (2015).

### V. Baseline Projections and Overview
- Baseline projections: growth of "1.5 percent this year to 1.6 percent next year, and stay at this level throughout the medium term."
- Output gap: "-2.3 percent of potential GDP."
- Inflation path: "close to zero this year, before rising to one percent next year and to 1.7 percent over the medium term."
- Output gap closure: "The output gap is expected to close around 2020."

### VI. Investment Shock Scenario (Private Investment Shock)
- Shock design:
  - Private investment growth is cut "by one-fourth relative to baseline projections" (equivalent to "a half-percentage-point reduction per year or three percent cumulatively over the medium term").
  - Benchmarked as "about half of the decline in euro area business investment during 2007–14."
- Macroeconomic effects by 2020 (relative to April 2015 WEO baseline):
  - Output: "lower output by around 1¼ percent below the baseline by 2020."
  - Inflation expectations and inflation: "fall."
  - Real corporate interest rates: "higher by 65 basis points in 2020."
  - Current account: "improves by 0.4 percentage points of GDP by 2020."
  - Output gap: "would widen by nearly one percentage point."
- Transmission channels:
  - Knock-on effects to households via labor income and wealth effects.
  - Weaker domestic demand depresses imports.
  - Higher real interest rates lower competitiveness.
- Public debt effects:
  - Public debt-to-GDP ratio rises "by 4½ percentage points" on average.
  - Country-specific increases: Greece "(+12 percentage points), Italy (+5½), Portugal (+5¾) and Spain (+5¼)."

### VII. Investment Shock plus Sovereign/Corporate Risk Premium Shock
- Additional shock design:
  - Simultaneous increase of "100 basis points in sovereign and corporate risk premia" in Greece, Ireland, Italy, Portugal, and Spain.
  - Magnitude similar to "the increase in Spanish 10-year sovereign bond yields during late June-July of 2012."
- Macroeconomic effects by 2020 (relative to baseline):
  - Output loss: "would increase to nearly two percent by 2020."
  - Output gap: "would widen by around 1¼ percentage points by 2020 and take an additional three to four years to close."
  - Real corporate interest rate: increases by "200 basis points" in highly indebted countries (reflecting mainly lower inflation).
  - Unemployment: "would be higher by 0.6–1.2 percentage points."
  - Nominal wage inflation: "is expected to decline by around 1.5 percentage points for the euro area with some cross-country variations."
  - Public debt-to-GDP ratio increases in high-debt countries: Greece "+17 percentage points; Italy and Portugal +9; Spain +8."
- Additional implications:
  - With no policy response, "negative shocks would push the euro area back into recession."
  - Financial fragmentation: risk premia and real rates diverge across countries.
  - The unemployment increase is "likely a lower-bound estimate" because the model "does not fully incorporate nominal wage rigidities."

### VIII. Further Dynamics: Low Inflation, Debt-Deflation, and Rebalancing
- Low inflation trajectory:
  - Inflation "would also fall close to zero through the medium term, as a result of the wider output gap."
  - Low inflation could lead to "unfavorable debt-deflation dynamics."
- Debt-deflation mechanisms:
  - Low inflation or deflation "redistributes wealth from debtors to creditors, pushing down the economy-wide propensity to consume."
  - This would "delay the much-needed recovery in business investment and capital stock accumulation," lowering potential growth and feeding back to expected future growth.
  - Such debt-deflation-like dynamics "could occur in countries with high public or private debt levels" though "not fully captured by the scenarios in this paper."
- Rebalancing and competitiveness:
  - Current account improvements largely reflect "import compression."
  - Low inflation for the euro area "would require deflation for the countries that need to achieve relative price adjustment."
  - Combined with "downward nominal wage rigidities," this implies "more labor shedding" and worsened unemployment.
  - Because downward nominal wage rigidities and the feedback loop of low inflation "are not directly built in the scenarios, the impact on output would likely be worse."

### IX. Key Quantitative Results and Country Breakdown (Selected 2020 Deviations from April 2015 WEO Baseline)
- Baseline and medium-term:
  - Growth path: "1.5 percent this year to 1.6 percent next year."
  - Output gap: "-2.3 percent of potential GDP."
  - Inflation: "close to zero this year," "one percent next year," "1.7 percent over the medium term."
  - Output gap closure: "around 2020."
- Investment shock outcomes by 2020:
  - Euro area output: "-1¼ percent below the baseline by 2020."
  - Real corporate interest rates: "+65 basis points in 2020."
  - Current account: "+0.4 percentage points of GDP by 2020."
  - Public debt-to-GDP ratio: average "+4½ percentage points"; country specifics: Greece "+12", Italy "+5½", Portugal "+5¾", Spain "+5¼".
- Investment + risk premium shock outcomes by 2020:
  - Euro area output loss: "nearly two percent by 2020."
  - Output gap widening: "around 1¼ percentage points by 2020."
  - Real corporate interest rates in high-debt countries: "+200 basis points."
  - Unemployment increase: "0.6–1.2 percentage points."
  - Nominal wage inflation decline: "around 1.5 percentage points" for the euro area.
  - Public debt increases (high-debt countries): Greece "+17 percentage points; Italy and Portugal +9; Spain +8."
- Selected country-level 2020 deviations (Investment + risk premium shock; values are percentage-point or percent deviations as listed):
  - Germany: Real GDP "-1.6", Inflation "-1.3", Real Investment "-2.0", Real Exports "-2.3", Real Imports "-2.3", Current Account "0.6", Real Corporate Interest Rate "1.0", Real Competitiveness Index "1.3".
  - France: Real GDP "-1.7", Inflation "-1.2", Real Investment "-6.6", Real Exports "-2.2", Real Imports "-3.2", Current Account "0.6", Real Corporate Interest Rate "0.9", Real Competitiveness Index "1.0".
  - Italy: Real GDP "-1.9", Inflation "-1.2", Real Investment "-6.5", Real Exports "-1.9", Real Imports "-3.1", Current Account "0.6", Real Corporate Interest Rate "2.1", Real Competitiveness Index "0.5".
  - Spain: Real GDP "-2.2", Inflation "-1.2", Real Investment "-8.7", Real Exports "-2.6", Real Imports "-4.0", Current Account "1.0", Real Corporate Interest Rate "2.1", Real Competitiveness Index "1.0".
  - Greece: Real GDP "-3.5", Inflation "-1.2", Real Investment "-16.5", Real Exports "-1.8", Real Imports "-7.2", Current Account "2.0", Real Corporate Interest Rate "2.0", Real Competitiveness Index "0.4".
  - Ireland: Real GDP "-3.6", Inflation "-1.5", Real Investment "-17.5", Real Exports "-4.9", Real Imports "-3.6", Current Account "4.9", Real Corporate Interest Rate "2.3", Real Competitiveness Index "6.0".
  - Portugal: Real GDP "-2.3", Inflation "-1.2", Real Investment "-7.7", Real Exports "-2.6", Real Imports "-3.7", Current Account "0.7", Real Corporate Interest Rate "2.0", Real Competitiveness Index "0.5".
  - Euro area aggregate: Real GDP "-1.9", Inflation "-1.3", Real Investment "-7.1", Real Exports "-2.3", Real Imports "-3.0", Current Account "0.7", Real Corporate Interest Rate "1.3", Real Competitiveness Index "1.0".

### X. Policy Implications and Recommendations
- Near-term priorities:
  - "Continued monetary accommodation to lift demand and inflation expectations."
  - Strengthen "bank and corporate balance sheets to enhance the effectiveness of monetary transmission."
  - "Make use of available fiscal space."
- Structural and long-term actions:
  - Reforms to "permanently raise productivity" by addressing "structural gaps in labor, product, and capital markets."
  - Policies to "raise labor participation" to mitigate aging-related effects.
- Overall assessment:
  - The euro area is "vulnerable to shocks that could lead to a prolonged period of low growth and inflation."
  - "Insuring against the risks of stagnation would require addressing both longer-term structural issues and crisis legacies."

*Source: IMF Working Paper — 5. Simulation Results: Investment and Risk Premium Shock (excerpt).*

### References __________________________________________________________________24

### References __________________________________________________________________24

### Figures

- 1. Actual and Pre-crisis Trend Output ___________________________________________5
- 2. Actual and Potential Output _________________________________________________6
- 3. Contribution to Growth in Hours Worked per Capita _____________________________8
- 4. Simulation Results: Investment Shock _________________________________________19

*Source: _wp1609 - References __________________________________________________________________24*

### 5. Simulation Results: Investment and Risk Premium Shock__________________________21

### 5. Simulation Results: Investment and Risk Premium Shock

### I. Motivation
- Since the global financial crisis, growth in output per capita in the euro area has stalled and the gap with the United States has widened.
- In 2014, output per capita in the euro area remained at the same level as in the mid-2000s.
- In PPP terms, nominal GDP per capita in the euro area is nearly $15,000 below that in the United States.
- Potential growth slowed in advanced economies well before the global financial crisis, driven mainly by declining total factor productivity (TFP) growth.
- Potential output estimates for major advanced economies have been revised down dramatically since the crisis.
- Baseline expectation: subdued medium-term growth and inflation, leaving the euro area vulnerable to shocks given high unemployment, public and private indebtedness, and limited policy space.

*Key numeric references from motivation*
- Output per capita indices use 1991=100 for real output per capita charts.
- Pre-crisis trend defined as trend growth over 1991-2007.

---

### II. Output per Capita: Diagnosis and Prospects

A. Labor
- Supply-side decomposition: output per capita = labor input per capita + capital per capita + total factor productivity.
- Before the crisis, rising labor force participation and declining unemployment offset a shrinking working-age population (aged 15-64 years).
- During the crisis, contribution of labor to per-capita growth in the euro area turned negative due to:
  - slower rise in labor force participation,
  - working-age population growth slower than total population,
  - higher unemployment.
- Comparison notes:
  - United States: decline in labor inputs driven by decline in labor force participation, shrinking working-age population, and rising unemployment.
  - Japan: decline in labor inputs driven mainly by shrinking working-age population.
- Demographics and projections:
  - Working-age population growth projected to decline significantly in advanced economies.
  - For the euro area, labor force expected to expand by 0.3 percent annually over the medium term (WEO, April 2014), about one-third of level during 2002-07.
- Implication: raising employment growth above pre-crisis levels requires significant reduction in structural unemployment.

B. Capital
- Capital accumulation slowdown accelerated during the crisis.
- United States saw a larger decline in capital accumulation during the global financial crisis but has since experienced a strong pickup in investment; euro area investment expanded only moderately since H2 2014.
- Result: capital is growing more slowly than population; particularly sharp decline in countries such as Greece and Italy.
- Historical pattern: the ratio of investment-to-capital (I/K) has fallen significantly since the crisis and, based on past financial crises, I/K and capital stock growth are likely to remain below pre-crisis levels for some time.
- Time to recovery: even where capital per capita growth has partially recovered (e.g., United States), a complete recovery likely to take a decade or more (Hall, 2014).

C. Total Factor Productivity (TFP)
- Labor productivity (output per hour worked) in euro area grew faster than the United States until mid-1990s; since then euro area productivity growth has fallen below U.S. levels until the crisis.
- TFP growth slowed in most euro area economies; negative TFP growth since early 2000s for Italy, and negative during the crisis for Greece and a few others.
- Service sector productivity slowdown explains much of the TFP decline, linked to slower adoption and diffusion of ICT.
- Unlike the United States (where service sector productivity has picked up), euro area service productivity remains well below pre-crisis peaks in countries such as Germany and Italy.
- Outlook:
  - Overall productivity growth in the euro area likely to remain weak.
  - Baseline expectation: potential growth rises only slightly from 0.7 percent during 2008-14 to about 1.1 percent during 2015–20, versus 1999–2007 average of 1.9 percent (WEO, April 2015).
  - Slow progress on addressing crisis legacies likely to weigh on aggregate demand.

---

### III. Crisis Legacies: Progress and Prospects

A. High Unemployment
- Euro area unemployment remains high despite improvements: nearly 11 percent in the euro area; 25 percent in Greece.
- Long-term unemployed share (unemployed > 12 months) continues to increase, raising risks of skill erosion and hysteresis.
- High youth unemployment risks creating a “lost generation.”
- Projected NAIRU (natural rate):
  - Italy: NAIRU projected to remain higher than during the crisis over the medium term.
  - France: NAIRU projected to remain at the crisis level over the medium term.
  - Spain: NAIRU expected to decline significantly from unprecedented levels but remain above 15 percent over the medium term.
- Recovery time illustration:
  - Without significant pick-up in growth, it could take around 7 to 10 years for Italy and Spain to reduce unemployment to pre-crisis levels (sensitive to forecast growth and Okun’s coefficient).
- Policy note: faster implementation of structural reforms and more spending on active labor market policies would help increase employment opportunities, especially for youth.

B. High (Private Sector) Debt
- Non-financial corporate (NFC) debt-to-equity ratios have been falling in most euro area countries, supported by financial surpluses used to pay down debt.
- Spain and Ireland recorded relatively strong reductions in NFC debt-to-GDP ratios.
- Spain: NFC debt reduction of nearly 20 percentage points from the peak driven by declining corporate borrowing and debt repayment through asset sales.
- Deleveraging effects observed:
  - Fall in corporate borrowing, investment decline, sharp increase in savings, significant reduction in employment (Spain example).
- Historical evidence: based on past corporate deleveraging episodes, two-thirds of the increase in debt is subsequently reduced.
  - If euro area deleveraging follows similar path, sizable deleveraging needs remain and present a headwind for investment recovery.
  - Example implication: if accumulated debt were to fall by two-thirds, it would imply a further reduction of nine percentage points of GDP for the euro area as a whole.
- Household sector:
  - High household debt in some countries following housing boom-bust cycles.
  - After five to seven years of adjustment, housing prices near troughs similar to past episodes, but domestic demand weaker—possibly due to higher household debt at peak and large increase during boom.
  - Household debt-to-GDP ratios have come down by 10-20 percentage points in high-debt countries but remain significantly above pre-boom levels, risking a prolonged debt overhang that weighs on spending.

---

### IV. An Illustrative Downside Scenario

- Baseline: subdued growth and inflation over medium term due to low potential growth, high unemployment, heavy real debt burdens, and weak balance sheets that suppress demand.
- Vulnerability: subdued medium-term prospects make euro area susceptible to negative shocks which, combined with limited policy space, could push the economy into stagnation.
- Policy space constraints:
  - Unconventional monetary policy may have reached limits; policy rate cannot be lowered further below zero.
  - Fiscal space limited overall; short-run fiscal policy constrained to automatic stabilizers and long-run fiscal policy constrained by stabilizing debt-to-GDP ratios.
- Economic dynamics under negative shocks:
  - Interest rate–inflation pairs expected to move toward equilibrium in circle B (inflation close to 2 percent) in baseline; negative shocks could keep economy in circle A (low inflation/low growth).
  - Negative shocks can create self-reinforcing low growth-low inflation equilibria if no further monetary or fiscal support is available.
- Channels of amplification from unaddressed legacies:
  - Markets may punish higher-debt countries with larger increases in borrowing costs, increasing risk of debt-deflation spirals.
  - Low inflation could hinder unwinding of external imbalances by making it harder for real prices and wages to adjust, forcing painful nominal adjustments.
- Two illustrative simulations (using FSGM; outcomes measured against April 2015 WEO baseline):
  1. Private investment shock.
  2. Private investment shock plus risk premium shock.
- Simulation assumptions:
  - Unconventional monetary policy held at limits (no more unconventional action than in baseline).
  - Policy responses limited to conventional monetary policy and fiscal policy.
  - Due to zero lower bound and limited fiscal space, monetary policy cannot be eased further and fiscal policy cannot provide stimulus beyond automatic stabilizers in the short run.
- Modelling notes:
  - Simulations conducted using the Flexible System of Global Models (FSGM) in coordination with IMF Research Department.
  - FSGM comprises three core models (G20MOD, EUROMOD, EMERGMOD); is semi-structural; trade, labor supply, and inflation are reduced form; supply determined by aggregate Cobb-Douglas production function; monetary and fiscal policies endogenously set with simple rules.

*Key numeric and technical references for scenario and modelling*
- Baseline potential growth: 0.7 percent during 2008-14; about 1.1 percent during 2015–20; 1999–2007 average 1.9 percent (WEO, April 2015).
- Euro area labor force medium-term expansion: 0.3 percent annually (WEO, April 2014).
- Unemployment levels: nearly 11 percent (euro area), 25 percent (Greece).
- Deleveraging example: near 20 percentage points reduction in NFC debt-to-GDP for Spain from peak.
- Deleveraging implication example: two-thirds fall in accumulated debt → further reduction of nine percentage points of GDP for euro area.

*Simulations provided by B. Hunt and S. Mursula (IMF); model documentation: Andrle and others (2015).*

*Source: IMF Working Paper — 5. Simulation Results: Investment and Risk Premium Shock (excerpt).*

### 1.5 percent this year to 1.6 percent next year, and stay at this level throughout the medium

### 1.5 percent this year to 1.6 percent next year, and stay at this level throughout the medium term

### Overview
- Baseline projections: growth of "1.5 percent this year to 1.6 percent next year, and stay at this level throughout the medium term."
- Output gap: "-2.3 percent of potential GDP."
- Inflation path: "close to zero this year, before rising to one percent next year and to 1.7 percent over the medium term."
- Output gap closure: "The output gap is expected to close around 2020."

### Investment shock scenario (private investment shock)
- Shock design:
  - Private investment growth is cut "by one-fourth relative to baseline projections" (equivalent to "a half-percentage-point reduction per year or three percent cumulatively over the medium term").
  - This is benchmarked as "about half of the decline in euro area business investment during 2007–14."
- Macroeconomic effects by 2020:
  - Output: "lower output by around 1¼ percent below the baseline by 2020."
  - Inflation expectations and inflation: "fall."
  - Real corporate interest rates: "higher by 65 basis points in 2020."
  - Current account: "improves by 0.4 percentage points of GDP by 2020."
  - Output gap: "would widen by nearly one percentage point."
- Transmission channels emphasized:
  - Knock-on effects to households via labor income and wealth effects.
  - Weaker domestic demand depresses imports.
  - Higher real interest rates lower competitiveness.
- Public debt effects:
  - Public debt-to-GDP ratio rises "by 4½ percentage points" on average.
  - Country-specific increases: Greece "(+12 percentage points), Italy (+5½), Portugal (+5¾) and Spain (+5¼)."

### Investment shock plus sovereign/corporate risk premium shock
- Additional shock design:
  - Simultaneous increase of "100 basis points in sovereign and corporate risk premia" in Greece, Ireland, Italy, Portugal, and Spain.
  - The magnitude is similar to "the increase in Spanish 10-year sovereign bond yields during late June-July of 2012."
- Macroeconomic effects by 2020 (compared to baseline):
  - Output loss: "would increase to nearly two percent by 2020."
  - Output gap: "would widen by around 1¼ percentage points by 2020 and take an additional three to four years to close."
  - Real corporate interest rate: increases by "200 basis points" in highly indebted countries (reflecting mainly lower inflation).
  - Unemployment: "would be higher by 0.6–1.2 percentage points."
  - Nominal wage inflation: "is expected to decline by around 1.5 percentage points for the euro area with some cross-country variations."
  - Public debt-to-GDP ratio increases in high-debt countries (with larger magnitudes than the investment-only shock): Greece: "+17 percentage points; Italy and Portugal: +9; Spain: +8."
- Additional implications:
  - With no policy response, "negative shocks would push the euro area back into recession."
  - Financial fragmentation: risk premia and real rates diverge across countries.
  - The unemployment increase is "likely a lower-bound estimate" because the model "does not fully incorporate nominal wage rigidities."

### Further dynamics: low inflation, debt-deflation, and rebalancing
- Low inflation trajectory:
  - Inflation "would also fall close to zero through the medium term, as a result of the wider output gap."
  - Low inflation could lead to "unfavorable debt-deflation dynamics."
- Debt-deflation mechanisms highlighted:
  - Low inflation or deflation "redistributes wealth from debtors to creditors, pushing down the economy-wide propensity to consume."
  - This would "delay the much-needed recovery in business investment and capital stock accumulation," lowering potential growth and feeding back to expected future growth.
  - Such debt-deflation-like dynamics "could occur in countries with high public or private debt levels" though "not fully captured by the scenarios in this paper."
- Rebalancing and competitiveness:
  - Current account improvements largely reflect "import compression."
  - Low inflation for the euro area "would require deflation for the countries that need to achieve relative price adjustment."
  - Combined with "downward nominal wage rigidities," this implies "more labor shedding" and worsened unemployment.
  - Because downward nominal wage rigidities and the feedback loop of low inflation "are not directly built in the scenarios, the impact on output would likely be worse."

### Key quantitative results and country breakdown (selected figures from scenarios)
- Baseline and medium-term:
  - Growth path: "1.5 percent this year to 1.6 percent next year."
  - Output gap: "-2.3 percent of potential GDP."
  - Inflation: "close to zero this year," "one percent next year," "1.7 percent over the medium term."
  - Output gap closure: "around 2020."
- Investment shock outcomes by 2020:
  - Euro area output: "-1¼ percent below the baseline by 2020."
  - Real corporate interest rates: "+65 basis points in 2020."
  - Current account: "+0.4 percentage points of GDP by 2020."
  - Public debt-to-GDP ratio: average "+4½ percentage points"; country specifics: Greece "+12", Italy "+5½", Portugal "+5¾", Spain "+5¼".
- Investment + risk premium shock outcomes by 2020:
  - Euro area output loss: "nearly two percent by 2020."
  - Output gap widening: "around 1¼ percentage points by 2020."
  - Real corporate interest rates in high-debt countries: "+200 basis points."
  - Unemployment increase: "0.6–1.2 percentage points."
  - Nominal wage inflation decline: "around 1.5 percentage points" for the euro area.
  - Public debt increases (high-debt countries): Greece "+17 percentage points; Italy and Portugal +9; Spain +8."
- Table (selected country-level 2020 deviations from April 2015 WEO baseline):
  - Germany: Real GDP "-1.6", Inflation "-1.3", Real Investment "-2.0", Real Exports "-2.3", Real Imports "-2.3", Current Account "0.6", Real Corporate Interest Rate "1.0", Real Competitiveness Index "1.3".
  - France: Real GDP "-1.7", Inflation "-1.2", Real Investment "-6.6", Real Exports "-2.2", Real Imports "-3.2", Current Account "0.6", Real Corporate Interest Rate "0.9", Real Competitiveness Index "1.0".
  - Italy: Real GDP "-1.9", Inflation "-1.2", Real Investment "-6.5", Real Exports "-1.9", Real Imports "-3.1", Current Account "0.6", Real Corporate Interest Rate "2.1", Real Competitiveness Index "0.5".
  - Spain: Real GDP "-2.2", Inflation "-1.2", Real Investment "-8.7", Real Exports "-2.6", Real Imports "-4.0", Current Account "1.0", Real Corporate Interest Rate "2.1", Real Competitiveness Index "1.0".
  - Greece: Real GDP "-3.5", Inflation "-1.2", Real Investment "-16.5", Real Exports "-1.8", Real Imports "-7.2", Current Account "2.0", Real Corporate Interest Rate "2.0", Real Competitiveness Index "0.4".
  - Ireland: Real GDP "-3.6", Inflation "-1.5", Real Investment "-17.5", Real Exports "-4.9", Real Imports "-3.6", Current Account "4.9", Real Corporate Interest Rate "2.3", Real Competitiveness Index "6.0".
  - Portugal: Real GDP "-2.3", Inflation "-1.2", Real Investment "-7.7", Real Exports "-2.6", Real Imports "-3.7", Current Account "0.7", Real Corporate Interest Rate "2.0", Real Competitiveness Index "0.5".
  - Euro area aggregate: Real GDP "-1.9", Inflation "-1.3", Real Investment "-7.1", Real Exports "-2.3", Real Imports "-3.0", Current Account "0.7", Real Corporate Interest Rate "1.3", Real Competitiveness Index "1.0".

### Policy implications and recommendations
- Near-term policy priorities:
  - "Continued monetary accommodation to lift demand and inflation expectations."
  - Strengthen "bank and corporate balance sheets to enhance the effectiveness of monetary transmission."
  - "Make use of available fiscal space."
- Structural and long-term actions:
  - Reforms to "permanently raise productivity" by addressing "structural gaps in labor, product, and capital markets."
  - Policies to "raise labor participation" to mitigate aging-related effects.
- Overall assessment:
  - The euro area is "vulnerable to shocks that could lead to a prolonged period of low growth and inflation."
  - "Insuring against the risks of stagnation would require addressing both longer-term structural issues and crisis legacies."

*Source: IMF staff estimates and scenario analysis as presented in the provided content.*

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_Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/wp/2016/_wp1609.pdf_