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Global current account adjustment: trade implications for the euro area countries

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Abstract

Although the euro area is not one of the major players in current global imbalances, the rebalancing of the current global imbalances is coupled with a significant appreciation of the euro against. In this paper, I present estimations of trade equations for individual euro area countries using a vector error correction model. Each euro area member has got a different trade elasticity, in the short as well as in the short run. Results show that exchange rate innovations affect individual euro area countries at different rates, complicating the response of the euro area’s one-size-fits-all monetary policy.

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Notes

  1. IMF world economic outlook.

  2. Honohan and Lane (2003 and 2004) identify slightly greater inflation dispersion in the euro area than among the U.S. states combined with a significant impact of exchange rate movements on inflation movements indicating inflation differentials due to different trade patterns and exchange rate pass through behaviour. Angeloni and Ehrmann (2004) examine the correlation between output gaps and inflation differentials caused by exchange rate changes. However, they found that exchange rate changes caused inflation differentials only by a small extent. ECB (2003) found inflation dispersion in the euro area to be about twice as big as across the German Bundesländer, the Spanish Autonomous Communities and the Italian cities.

  3. Since the beginning of the 1990s, the average business cycle synchronization of each euro area country with respect to the others has improved in all cases. Some smaller countries have more idiosyncratic business cycles than larger countries or countries that trade more intensely with larger neighbours. (Benalal et al. 2006)

  4. A lower exchange rate pass through to trade prices may mute the responsiveness of the nominal trade balance. See Gust and Sheets (2006), Campa and Gonzalez Minguez (2006)) and Faruqee (2004) for more research done on the subject of exchange rate pass through in the euro area.

  5. The model features the production of non-tradable goods and home bias towards domestically produced goods. A transfer effect describes the link between an international current account change on the nominal and real exchange rate. In the real exchange rate effect the current account movement affects the prices of non-traded goods. The revaluation effect caused by the exchange rate changes and a redistribution of international indebtedness is also accounted for. Another key parameter in the model is the substitutability among traded goods and between traded and non-traded goods.

  6. Under these circumstances the exchange rate is not responding to news (demand shock) about the current account as strongly as under perfect substitutability, but to changes in the world distribution of wealth or in portfolio preferences.

  7. As for China, Blanchard et al. (2005) argue that in case the Chinese dollar peg was abandoned, the Chinese central banks would stops intervening, which means a loss of a big investor with extreme dollar preferences. Hence the effective euro exchange rate would depreciate even if the bilateral exchange rate appreciates.

  8. Edwards (2005) gives a detailed overview of research done on the U.S. current account and the dollar.

  9. See EC (2005) and Ahearne and von Hagen (2006) for a more detailed analysis of the euro area’s involvement in the global imbalances.

  10. The current account balances considered here are also against other euro area members, not just against external trading partners.

  11. EC (2006) and Ahearne et al. (2007) deliver further insight into euro area internal and external imbalances.

  12. Due to data availability problems the focus is on trade in goods. This can also be justified by looking at the U.S. trade balance decomposed into goods and services. The U.S. services balance is in a slight surplus for the last 20 years and dwarfs compared to the large deficit in the goods balance. (BEA)

  13. ECB Monthly Bulletin April 2006 and December 2001.

  14. Comparing this to the overall current account balance, the difference is quite striking. Ireland is in the special position of running a rather larger trade deficit in services (almost 7% of GDP). As Ireland is a clear outlier, I will not discuss the trade in services here. For a more detailed description of Irish trade in goods and services see Lane and Ruane (2006).

  15. Other studies conducted estimating the income and exchange rate elasticities are Marquez, J. (Marquez 1990, 2005), Hooper et al. (1998), Lee and Chinn (1998) and Boyd et al. (2001).

  16. Here the exchange rate is expressed using indirect quotation, i.e. expressing the foreign currency in terms of the domestic currency. Thus a rise in the value of the exchange rate reflects an appreciation of the currency.

  17. The lower case letters stand for the logarithms of the respective variable.

  18. As there was no trade data available for 2005 at the time the trade weights were calculated, the trade weights of 2004 are applied for the first two quarters in 2005.

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  1. National University of Ireland, Galway, Seeblick 1, 19395, Plau am See, Germany

    Kristin Langwasser

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Langwasser, K. Global current account adjustment: trade implications for the euro area countries. Int Econ Econ Policy 6, 115–133 (2009). https://doi.org/10.1007/s10368-009-0135-2

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