Real exchange rate synchronization in the NAFTA region

Abstract

PurposeThe literature mostly investigates the impact of trade and financial integration on business cycle synchronization. The author differs by focusing on the real effective exchange rate as the target variable in the North American Free Trade Agreement (NAFTA) region. In particular, the author investigates synchronization by analyzing the short- and long-run dynamics of the real effective exchange rates of Canada, Mexico and the US for 2008–2019.Design/methodology/approachThe author first employs stationarity and cointegration tests to specify and estimate the long-run equilibrium relation between the real effective exchange rates of Canada, Mexico and the US. The author then specifies and estimates an error-correction model for each real effective exchange rate in order to investigate whether the adjustment in eliminating disequilibrium is asymmetric.FindingsThe results indicate that the real effective exchange rates of Canada, Mexico and the US are cointegrated with only one long-run equilibrium relation. Canada's real effective exchange rate responds symmetrically to eliminate both negative and positive disequilibrium with a similar speed of adjustment. However, the response of Mexico's real effective exchange rate is asymmetric, as it responds to eliminate only positive disequilibrium. The US real effective exchange rate does not respond to disequilibrium, perhaps because it has a large economy with much stronger competition beyond the NAFTA region than both Canada and Mexico.Originality/valueThis is the first study that investigates real effective exchange rate synchronization in the NAFTA region.