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

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 expen-diture 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 govern-ment spending and frictions preventing factor prices from equal-izing across sectors considerably improve the fit of the model. (JEL E31, E62, F14, F33, F45, H20, H50)