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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