November 17, 2015/by iMFdirect

By Jorg Decressin and Prakash Loungani

Devaluation is often part of the remedy for a country in financial trouble. Devaluation boosts the competitiveness of a country’s exports and curtails imports by making them more costly. Together, the higher exports and the reduced imports generate some of the financial resources needed to help the country get out of trouble. For countries that belong to—and want to stay in—a currency union, however, devaluation is not an option. A remedy for these economies that has generated a lot of debate is so-called internal devaluation–a boost to competitiveness not through an (external) devaluation of the currency but by internal means, such as wage cuts or wage moderation.

Can such internal devaluations work? Our recent paper provides an answer.  The main take-away from the paper is that, if undertaken by several crisis-hit countries at the same time, wage moderation can only work well if supported by accommodative monetary policies. In the absence of such policies, wage moderation does not deliver much of a boost to output in the countries that are undertaking it, and also ends up lowering output in the euro area as a whole.

IMF Press Office