Working Paper: NBER ID: w21979
Authors: Paul R. Bergin; Reuven Glick; Jyh-Lin Wu
Abstract: While economic theory highlights the usefulness of flexible exchange rates in promoting adjustment in international relative prices, flexible exchange rates also can be a source of destabilizing shocks. We find that when countries joining the euro currency union abandoned their national exchange rates, the adjustment of real exchange rates toward purchasing power parity (PPP) became faster. To disentangle the possible causes for this finding we develop a novel methodology for conducting counterfactual simulations of an estimated VECM that distinguishes between the roles of the nominal exchange rate as an adjustment mechanism and as a source of shocks. We find evidence that prior to joining the euro currency union, member countries relied upon exchange rate adjustments as a mechanism to correct for PPP deviations arising from divergent domestic inflation rates. But the loss of the exchange rate as an adjustment mechanism after the introduction of the euro was more than compensated by the elimination of the exchange rate as a source of shocks, in combination with faster adjustment in national price indices. These findings support claims that flexible exchange rates are not necessary to promote long-run international relative price adjustment.
Keywords: Euro; Real Exchange Rate; Purchasing Power Parity; VECM
JEL Codes: F01; F15; F31
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Adjustment of real exchange rates toward purchasing power parity (PPP) after joining the euro currency union (F31) | Faster adjustment of real exchange rates (F31) |
| Elimination of exchange rate shocks (F31) | Faster adjustment of real exchange rates (F31) |
| Loss of exchange rate as an adjustment mechanism compensated by elimination of exchange rate as a source of shocks (F32) | Faster adjustment of real exchange rates (F31) |
| Flexible exchange rates not necessary to promote long-run international relative price adjustment (F31) | Increased speed of adjustment after euro adoption (F36) |
| Halflife of the real exchange rate decreased from 239 years to 135 years (F31) | Faster adjustment of real exchange rates (F31) |