Real exchange rate convergence in the euro area: Evidence from a dynamic factor model

Abstract

This paper uses a time-varying error-correction model to measure the speed of real exchange rate (RER) convergence of the original European monetary union (EMU) member countries both before and after the introduction of the euro with those of a larger sample of European countries. These estimates are then incorporated into a multivariate dynamic factor model to identify common European and EMU-specific components determining the temporal dynamics of RER adjustment across these two country groupings. We find the convergence speed in the EMU members to have accelerated substantially from the mid-2000s, stalling only briefly in the wake of the Great Recession of 2007–09 and the subsequent European debt crisis of 2010–12. In contrast, the speed of RER adjustment for the larger sample of European countries displays a secular slowdown lasting to the end of the sample in the late 2010s. The evidence suggests that the EMU members in fact experienced a genuine exchange rate stabilization, particularly during the latter years of the sample.