Mr. Bas B. Bakker, Marta Korczak, and Mr. Krzysztof Krogulski
In the last decade, over half of the EU countries in the euro area or with currencies pegged to the euro were hit by large risk premium shocks. Previous papers have focused on the impact of these shocks on demand. This paper, by contrast, focuses on the impact on supply. We show that risk premium shocks reduce the output level that maximizes profit. They also lead to unemployment surges, as firms are forced to cut costs when financing becomes expensive or is no longer available. As a result, all countries with risk premium shocks saw unemployment surge, even as euro area core countries managed to contain unemployment as firms hoarded labor during the downturn. Most striking, wage bills in euro area crisis countries and the Baltics declined even faster than GDP, whereas in core euro area countries wage shares actually increased.