Please use this identifier to cite or link to this item: https://hdl.handle.net/10419/222038 
Year of Publication: 
2018
Series/Report no.: 
IEHAS Discussion Papers No. MT-DP - 2018/25
Publisher: 
Hungarian Academy of Sciences, Institute of Economics, Budapest
Abstract: 
We investigate (i) the characteristics of real economic and price convergence, (ii) the relationship between economic growth (convergence) and real exchange rate (RER) misalignments within the European Union (EU) during the period 1995-2016. In addition to the relative external price level of GDP, we quantified an alternative indicator for the RER: the internal relative price of services to goods, as measured from the expenditure side of GDP. We interpreted RER-misalignments as deviations from levels consistent with levels of economic development among EU countries. Regarding real convergence, the "catching up" of the less developed member states to the more affluent ones within the EU was expressly rapid in terms of relative per capita growth measured at current PPPs; it was less impressive if measured at constant PPPs, and rather modest in terms of relative real GDP-growth. As for price levels and the relative price of services to goods, a rapid convergence could be observed until the international financial crisis, but this process halted in 2008. Using pooled OLS and dynamic panel techniques, we found that within the EU there is a negative relationship between the contemporaneous sign of RER-misalignment (based on both the external price level and internal relative prices) and economic growth: over- (under-) valuations are associated with lower (higher) growth. This is mainly due to developments in countries operating under fixed exchange rate regimes. Our results indicate that the level of development does not influence the strength of the growth-misalignment relationship within the EU. These results are robust to the applied panel estimation method. Regarding the external price level, we find that the positive relationship between undervaluation and growth diminishes with increasing size of undervaluation. The aggregate effect of misalignments is significantly negative on both export market shares and the ratio of gross fixed capital formation to GDP: both the competitiveness and the investment channel play an important role in the relationship between growth and RER misalignments. As an extension, we analyse the relationship between growth and the misalignment of wages from productivity levels; "wage-misalignments" are also negatively associated with economic growth. Although our study carries policy messages - in particular, mild real exchange rate undervaluations are positively, while overvaluations are negatively associated with growth and real economic convergence - the RER is an endogenous variable, which is not under direct policy control. Our results point to the importance of a growth strategy avoiding overvaluation on the one hand, and to the futility of aiming at excessive undervaluation, on the other.
Subjects: 
real economic and price level convergence
external and internal relative prices
exchange rate misalignment
JEL: 
E01
F45
O40
O47
O52
P22
P27
Document Type: 
Working Paper

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