Professor Gomez-Gonzalez will speak on currency unions with particular emphasis on Spain at 4pm Tuesday April 26th in LL309 or E205 Dealy Hall. This ongoing research with coauthor Daniel M. Rees Senior Economist at the Reserve Bank of Australia studies how Spain would have fared outside the Euro area during the recent crisis.
As part of a currency union, Spain could not devalue its currency in response to the double-dip recession of 2009 and 2013. Instead it had to undergo an ‘internal devaluation’ which can be very costly as it reduces employment and income growth.
The paper presents a two-economy New Keynesian model à la Gali and Monacelli (2005) with a structural break when Spain joined the Euro area in 1999. Before that, Spain is assumed to follow a Taylor rule which responds to domestic inflation and domestic output only.
The estimation of the model accounts for the structural break in 1999 because agents are forward looking, this structural break might cause changes in behavior before 1999. The estimation methodology infers breaks in beliefs of households and firms from the model’s observable variables.
The paper’s counterfactual exercises find that if hit by the same shocks of 2009-2014, Spain outside the Euro would have experienced a sizable exchange rate depreciation. This would have caused inflation, which in turn would have triggered an increase in the policy rate.
Output, consumption, and investment growth would have exhibited a similar pattern outside the Euro area as it did within. The evidence so far shows that the most relevant shocks in driving fluctuations in Spain during the crisis (aggregate technology, Euro demand shocks) are shocks outside the control of domestic monetary policy.
