With the start of Monetary Union, the disappearance of exchange rate risk premia and the unprecedented fall in interest rates facilitated capital inflows and encouraged risk-taking behaviour, resulting in a rapid rise in private debt and a property boom. The expectation of higher levels of income led to excessive consumption and investment relative to the supply capacity of the Spanish economy.
This continuous demand pressure generated a positive inflation differential vis-à-vis the rest of the euro area, leading to a strong appreciation of the real exchange rate and an erosion of price competitiveness.13 When the crisis hit, the subsequent adjustment was severe – with unemployment at levels above 25%, a rapid erosion of the fiscal position and a number of bank failures – leading to a significant contraction in both domestic demand and real GDP.