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Adjustment in relative prices and wages in response to asymmetric shocks---”internal
devaluation”---is a key rebalancing mechanism to ensure employment and macroeconomic
stability across regions sharing the same currency. We carry out a systematic analysis of the
price, wage and employment adjustment across US Metropolitan Statistical Areas (MSAs)
in response to the house price cycle during the Great Recession. Relative to the literature,
we study heterogeneity in the real exchange rate adjustment by sector, distinguishing goods,
services, distribution and construction, at the disaggregated MSA level. For each sector, we
analyze how relative prices adjust to relative wages (cost) and employment (slack) dynamics
across MSAs. We document that, while relative prices responds negatively to sectoral
unemployment, they adjust in opposite directions across goods and services in response to
negative asymmetric shocks to house prices. We find evidence of decreasing competitiveness
and relative increase in markups in services that may help explain this pattern. Overall,
real exchange rates do not depreciate in the worst-hit MSAs, despite the large differential
response in local employment.
