Readdressing the Trade Effect of the Euro: Allowing for Currency Misalignment

Abstract

Die Dis cus si on Pape rs die nen einer mög lichst schnel len Ver brei tung von neue ren For schungs arbei ten des ZEW. Die Bei trä ge lie gen in allei ni ger Ver ant wor tung der Auto ren und stel len nicht not wen di ger wei se die Mei nung des ZEW dar.Dis cus si on Papers are inten ded to make results of ZEW research prompt ly avai la ble to other eco no mists in order to encou ra ge dis cus si on and sug gesti ons for revi si ons. The aut hors are sole ly respon si ble for the con tents which do not neces sa ri ly repre sent the opi ni on of the ZEW.Download this ZEW Discussion Paper from our ftp server:ftp://ftp.zew.de/pub/zew-docs/dp/dp10023.pdf Non-technical SummaryThe run-up to the Economic and Monetary Union (EMU) of the EU has been dominated by tension between a big aspiration and a big concern. The aspiration was that a common currency would reinvigorate the single market program by establishing more cross-country transparency, wiping out all exchange rate uncertainty, and lowering administrative cost of intra-European trade. Euro members were hoping for a significant rise in bilateral trade generating sizable welfare gains across the currency union.The concern was that some member countries might face problems in absorbing shocks in ways that are consistent with a common anchor. Absent nominal exchange rate adjustment within the union, this would result in misalignments of real exchange rates and, thus, diverging competitiveness. Such misalignments have a trade effect that is of a different nature compared to the one triggered by a reduction in trade costs, as usually expected from a common currency. Lower trade costs affect countries in symmetric fashion, raising all countries exports and imports. In contrast, misalignment-induced trade effects are asymmetric, whereby bilateral exports and imports deviate in opposite direction from the benchmark case where bilateral purchasing power is maintained. In short, misalignments introduce a drifting apart of intra-euro area trade balances. The welfare implications are different, too. Higher exports from lower trade costs clearly indicate higher gains from trade. The same is not true, however, if higher exports reflect a deterioration of the terms of trade, as with a currency misalignment.In this paper, we use gravity methods to test whether this type of implicit currency misalignment has had a statistically significant impact on bilateral intra-euro area exports. We first extend the traditional gravity model to incorporate nominal exchange rates. A currency union may then raise the hypothetical "gravity-norm-level" of trade between member states, but may also cause misalignment-induced deviations from this norm. Guided by our extended gravity model, we then conduct a thorough empirical assessment of these two effects, using state-of-the art econometric methods. We find that the introduction of the euro has had a significant currency misalignment effect. The numbers tell us that an increase in relative nominal unit labour costs by 10% leads to a 7% reduction...

Essays on Wage Formation and Globalization

“…Our results show that competitiveness was indeed important only after the Euro was introduced in the year 1999, which is in line with the critique by Lagarde and the accompanying hypothesis of wage moderation driving export activity. In this perspective, our paper can be related to a recent work by Hogrefe, Jung, and Kohler (2012), who argue that the introduction of the Euro gave rise to currency misalignments. In line with their study we find at least weak evidence for interaction between the introduction of a common currency union, competitiveness and trade.…”