Modelling internal devaluation experiences in Europe: Rational or learning agents?

In this paper we study the experiences of wage and price mark-up adjustments (internal devaluation) in Germany (in the decade up to 2009) and Spain (in the 5-year after 2009) within the framework of the ECB's New Multi-Country Model (NMCM). The NMCM works both in a rational expectation environment and in a learning environment. We show that a learning environment (where agents take time to adapt to the new situation) appears well suited to capture the gradual wage and price adjustment of Germany and Spain. By contrast a rational expectation model appears more appropriate to describe the abrupt wage adjustment which took place in the Baltic States in 2008-09. The two environments appear to reflect the institutional differences between Germany and Spain on the one-hand and the Baltic States on the other hand. Moreover, in the learning environment, GDP and employment gains are delayed with respect to a rational expectation setting, but they are more long-lasting.