Abstract
We revisit the diagram developed by Krugman and Macedo (The economic consequences of the April 25th revolution, Krugman and Braga de Macedo, Economia III:435–483, 1979) to study the adjustment path of output and real wage gaps in a small open economy. Using time series data, we estimate sequences of real exchange rates that are consistent with internal and external balance for the Portuguese economy and use these estimates to plot its evolution during 1971–2017. Following a period of prolonged appreciation, we find that the real exchange rate fell below its equilibrium level during the 2011–2015 adjustment phase, which was driven by both declining nominal wages and improvements in terms of trade.
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Notes
- 1.
Blanchard and Portugal (2017) also summarize the recent macroeconomic adjustment of the Portuguese economy in terms of a diagram showing the deviations from “internal balance” and “external balance” but do not disentangle the contribution of relative prices.
- 2.
For the sake of simplicity, the model ignores the labor supply response to changes in real wages.
- 3.
Note that the external balance does not refer to a country’s state of intertemporal solvency. It refers instead to the non-accumulation of liabilities vis-à-vis the rest of the world. This is not necessarily a policy goal at each moment in time, but rather a reference point for what should happen (on average) in order for a country to remain solvent.
- 4.
This approach is adapted from Clark and MacDonald (1998).
- 5.
- 6.
Data on fundamental account, output gap, real exchange rate, estimated WRER, and real exchange rate gap are available from the corresponding author upon request. For details on the sources and construction of all data series, see the Annex.
- 7.
The relevant data series shows that the energy deficit at constant prices, which is interpretable as an indicator of oil dependency, has been decreasing over time (source in previous footnote).
- 8.
As pointed out by Braga de Macedo (1985), the real exchange rate based on unit labor costs underestimates the loss in competitiveness in this period because it ignores the cost of capital, which was increasing due to tight credit constraints.
- 9.
- 10.
See Abreu (2001) for a discussion of Portugal’s disinflation experience during 1984–1998.
- 11.
A simple arithmetic exercise using counterfactual oil prices equal to the 1990s’ average points to a direct negative impact on the trade balance ranging from 1.2% of GDP in 2000 to 2.9% of GDP in 2008 (for the data source, see Footnote 6).
- 12.
Additionally, China’s accession to the World Trade Organization in 2001 as well as the EU’s enlargement in 2004 led to an increase in competition both in Portugal’s traditional export markets and in terms of attracting FDI. Amador and Caldeira Cabral (2014) argue that the exporting sector had already recovered from these shocks by 2005. Reis (2013) doubts that these factors explain the slump.
- 13.
Lebre de Freitas et al. (2017) provide evidence that EMU membership helped mitigate investors’ risk perceptions regarding fiscal unsustainability during the bonanza episodes that affected the EU periphery prior to 2007. Eichenbaum et al. (2016) argue that IMF surveillance of Portugal ignored the possibility of a sudden stop.
- 14.
EU peer pressure was relaxed following the temporary suspension of the Stability and Growth Pack (SGP) by the EU’s Economic and Financial Affairs Council. Despite the government’s reliance on sizeable one-off measures to keep the deficit below its reference value (1.4% of GDP in 2002, 2.5% in 2003, and 2.3% in 2004), the European Council considered that Portugal had complied with the Treaty and the corrective procedures ended in May 2004. In June 2005, however, Constitutional Government XVII updated the deficit projections for 2005 and 2006. As a result, Portugal was again placed under the EDP in July (European Commission 2005).
- 15.
The program’s political and economic developments are analyzed in Torres and Lebre de Freitas (2019).
- 16.
Portugal also benefitted from the geopolitical instability generated by the Arab Spring, in 2011. Tourism activity picked up and created the incentives for quality improvements, in a virtuous cycle. All else being equal, the warranted real wage should have improved more during that period.
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The authors would like to thank João Amador and the editors for helpful comments on earlier versions of this paper. The views expressed in this article are those of the authors and do not reflect the views of the Federal Reserve Bank of St. Louis or the Federal Reserve System.
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Lebre de Freitas, M., Faria-e-Castro, M. (2021). The Krugman–Macedo Diagram Revisited. In: Brites Pereira, L., Mata, M.E., Rocha de Sousa, M. (eds) Economic Globalization and Governance. Springer, Cham. https://doi.org/10.1007/978-3-030-53265-9_13
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