Fiscal Policy, Relative Prices, and Net Exports in a Currency Union

Abstract

The hoped-for silver lining of euro-area austerity programs was to raise external competitiveness and improve current accounts. Using product- and industry-level data for 12 countries over the period 1999–2018, we show that reductions in government spending reduce prices and wages but only for products with low import content and industries with low export shares. This leads to asymmetric expenditure switching, with net exports improving through lower imports rather than higher exports. The standard small-open-economy model fails to rationalize these findings, but home bias in government spending and frictions preventing factor prices from equalizing across sectors considerably improve the fit of the model. (JEL E31, E62, F14, F33, F45, H20, H50)