Download Euro Region Debt Crisis and Exchange Rate Dynamics in EU Accession Countries

Euro Region Debt Crisis and Exchange Rate Dynamics in EU
Accession Countries
Sanja Grubacic, Ph.D and Yilma Gebremariam, Ph.D
This paper examines the relationship between fiscal imbalances and real exchange
rate dynamics in several Central and East European countries that are attempting
to achieve the various Maastricht convergence criteria. In this paper, we argue that
the interplay between the government budget deficits and real exchange rate
misalignments over the last several years has been among the major impediments
to the fuller integration process into European Union. Our findings suggest that the
accession process has implied an additional fiscal strain and unsustainable
movements of real exchange rates in several accession countries. The global
recession has perpetuated the existing structural imbalances and increased the
likelihood of conflict between the goals of internal and external macroeconomic
balance.
The purpose of our analysis is to estimate a simple reduced form real exchange
rate model to highlight the relationship between the real exchange rates, long-run
fundamentals, and short- run monetary variables, with a special emphasis on the
impact of government budget deficits. The theoretical framework for our empirical
analysis is an inter-temporal model of the real exchange rate determination in a small
open transitional economy. The assumption crucial to modeling economic adjustment
in a transitional economy is that the prices of non-tradable goods, although freed from
the government control, remain relatively rigid during the transition. The model
identifies the disturbances that are most likely to affect a country's real exchange rate,
and evaluates the situations where the inadequate policy-response to these
disturbances may induce and perpetuate exchange rate misalignment.
The
adjustment of the real exchange rates tends to exhibit asymmetry during the upward
and downward phases of business cycles. The timing, the policies, and the methods
used to achieve a satisfactory outcome in the accession process must be reevaluated
in the light of the latest global recession.
This paper argues in favor of policies that will help increase flexibility of prices and
reduce the monopoly powers in the private as well as public sectors, thereby
contributing toward more complete endogenous adjustment of the real exchange
rates. Achieving greater price flexibility, however, probably requires an even longer
period—a period during which more newly privatized enterprises become competitive,
the antitrust and bankruptcy laws are more strictly enforced, and the fiscal and legal
systems are transformed to support market institutions. In the short-run—a current
stage of transition—each country must find what combination of simultaneous use of
macroeconomic and nominal exchange rate polices would produce the best
combination of simultaneous impacts on goals of internal balance, external balance,
and economic restructuring.
Key Words: Real Exchange Rate, Budget Deficit, Misalignment, Policy Implications
_____________________________________________
Sanja Grubacic, [email protected]
Yilma Gebremariam, [email protected],
Department of Economics and Finance,Southern Connecticut State University,New Haven, CT