Downward Nominal Wage Rigidity and the Case for Temporary Inflation in the Eurozone

S ince 2008, the periphery of Europe has been suffering an economic contraction of a magnitude that in several countries is comparable to the US Great Depression. During the early 2000s, the periphery of Europe enjoyed rapid growth in domestic demand, wages, and employment. Much of this bonanza was fueled by large international capital infl ows. Figure 1 displays the current account, nominal hourly wages, and the rate of unemployment in fi ve peripheral eurozone countries between 2000 and 2011. In all fi ve countries, current accounts sharply deteriorated between 2000 and 2008. During this period, some countries increased their external debt position by more than 50 percent of GDP. This large amount of external borrowing fi nanced a boom in domestic demand and was accompanied by increases in nominal wages of about 50 percent. With the arrival of the international fi nancial crisis of 2008, external credit to peripheral Europe suddenly dried up, causing a sharp contraction in aggregate demand. However, nominal hourly wages, shown in the second column of Figure 1, far from falling, remained largely unchanged from the high levels they had reached during the boom years. The combination of weak aggregate demand and high labor costs was associated with widespread unemployment, shown in the third column of Figure 1. Downward Nominal Wage Rigidity and the Case for Temporary Infl ation in the Eurozone