Relevance of Exchange Rates on the Trade Imbalance in the Eurozone

Abstract

European monetary integration is causing economic imbalances because the optimal currency area criterion is not being properly met. Euro countries are experiencing chronic current account deficits. The purpose of this study is to explore the long-running divergent dynamics of real exchange rates and their determinants and influence. In this estimation, we find that the real effective exchange rate (REER) has a long term equilibrium relation to the balance of current account, the demographic aging effect, and the stage of development effect as a Euro-zone group. Also, we find that individual REER discrepancies have greatly diminished in recent years while the misalignments of individual and group REERs show a steady converging tendency of their equilibrium rates. The co-movement effect on the REER misalignment indicates a weak influence of determinant factors. In addition, the Euro-zone drives the undervalued rate of 3.44% with the current account deficit of 0.08% for the sample period, and the REER misalignment is not closely related to the trade deficit. The results for the future of the Eurozone would imply that the misalignments of currency cooperation members show an increasingly converging tendency of their equilibrium over time, and they also display co-integration regarding the current account balance and development phase as well as population aging.