The Krugman-Macedo diagram revisited

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.