Current Account Adjustment in the Euro-Zone: Lessons from a Flexible-Price-Model

This paper deals the ongoing current account adjustment process in the southern Euro - area countries. It applies an extended version of the Obstfeld/Rogoff (2005) model to Euro-Zone- imbalances and provides an interpretation of the results. I develop a five-region-version of the model, consisting of a EMU – deficit (GIPS)- and a EMU – surplus region besides the United States, Asia and OPEC. The model also allows for changes in the relative size of the tradable- to the non- tradable sector, induced by changes in the relative prices of tradable- to non-tradable goods. The paper shows the approximated sizes and the directions of price movements, which are implied by the current account adjustment process that started in the GIPS countries after the financial crisis. It argues, that declines in output and employment during the adjustment process follow intuitively from the model results. These output losses result from sticky prices in combination with a limited nominal depreciation of the common currency and the importance of intra-EMU adjustment. The paper further shows that supply-side changes, global rebalancing issues and the time horizon of the rebalancing process have an important impact on the size of the price movements. Despite the discussed weaknesses of the model, the analysis clearly suggests unfinished real effective exchange rate adjustment in Greece, Spain and Portugal implying further negative economic consequences on these economies by the rebalancing process. Italy might be an exception.