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Sectoral Productivity, Demand, and Terms of Trade: What Drives the Real Appreciation of the East European Currencies?

  • Vasily Astrov

    ()

    (The Vienna Institute for International Economic Studies, wiiw)

Since the start of transition, the currencies of most East European countries have experienced an abrupt real depreciation, followed by a trend real appreciation over the subsequent years. Within the framework of a panel-data study for eight Central European transition countries - Hungary, the Czech Republic, Poland, Slovakia, Slovenia, Bulgaria, Romania, and Croatia - over a period of up to 12 years, we attempt to explain their real exchange rate movements against the ECU/euro. Theory suggests that in the medium and long run, real exchange rate movements can only be explained by real shocks, such as the shifts in tastes and technology. We construct a model decomposing real exchange rate movements into two components the changing relative price of tradables (the shifts in terms of trade, reflecting the quality upgrading of the countries' exports) and the changing relative price of non-tradables, relating the latter variable to cross-sectoral productivity differentials (capturing presumably the so-called Balassa-Samuelson effect). Our findings suggest that not only the tradable sector productivity and the share of government in GDP, but also the terms of trade are significant determinants of the real exchange rate. However, controlling for sectoral productivities, we found no positive correlation between real exchange rate and per capita GDP, suggesting the relative unimportance of demand effects associated with rising income. The latter finding implies that the trend real appreciation in the countries involved (i.e. higher domestic inflation under a fixed exchange rate arrangement within the framework of monetary integration with the EU) may prove more pronounced than usually assumed due to the possible demand-driven component, as living standards and consumption patterns in transition economies are expected to converge to those currently observed in West European countries.

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File URL: http://www.wiiw.ac.at/sectoral-productivity-demand-and-terms-of-trade-what-drives-the-real-appreciation-of-the-east-european-currencies--dlp-533.pdf
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Paper provided by The Vienna Institute for International Economic Studies, wiiw in its series wiiw Working Papers with number 34.

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Date of creation: Apr 2005
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Publication status: Published as wiiw Working Paper
Handle: RePEc:wii:wpaper:34
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  1. Menzie Chinn & Louis Johnston, 1996. "Real Exchange Rate Levels, Productivity and Demand Shocks: Evidence from a Panel of 14 Countries," NBER Working Papers 5709, National Bureau of Economic Research, Inc.
  2. International Monetary Fund, 2001. "Interpreting Real Exchange Rate Movements in Transition Countries," IMF Working Papers 01/56, International Monetary Fund.
  3. László Halpern & Charles Wyplosz, 1997. "Equilibrium Exchange Rates in Transition Economies," IMF Staff Papers, Palgrave Macmillan, vol. 44(4), pages 430-461, December.
  4. Bhagwati, Jagdish N, 1984. "Why Are Services Cheaper in the Poor Countries?," Economic Journal, Royal Economic Society, vol. 94(374), pages 279-86, June.
  5. Irving B. Kravis & Robert E. Lipsey, 1982. "Towards an Explanation of National Price Levels," NBER Working Papers 1034, National Bureau of Economic Research, Inc.
  6. Mark P. Taylor, 1995. "The Economics of Exchange Rates," Journal of Economic Literature, American Economic Association, vol. 33(1), pages 13-47, March.
  7. Taylor Mark P. & Sarno Lucio, 2001. "Real Exchange Rate Dynamics in Transition Economies: A Nonlinear Analysis," Studies in Nonlinear Dynamics & Econometrics, De Gruyter, vol. 5(3), pages 1-26, October.
  8. Kenneth Rogoff, 1996. "The Purchasing Power Parity Puzzle," Journal of Economic Literature, American Economic Association, vol. 34(2), pages 647-668, June.
  9. Bela Balassa, 1964. "The Purchasing-Power Parity Doctrine: A Reappraisal," Journal of Political Economy, University of Chicago Press, vol. 72, pages 584.
  10. Jose De Gregorio & Alberto Giovannini, 1993. "International Evidence on Tradables and Nontradable Inflation," NBER Working Papers 4438, National Bureau of Economic Research, Inc.
  11. Jose De Gregorio & Holger C. Wolf, 1994. "Terms of Trade, Productivity, and the Real Exchange Rate," NBER Working Papers 4807, National Bureau of Economic Research, Inc.
  12. Alan M. Taylor, 1996. "International Capital Mobility in History: Purchasing-Power Parity in the Long Run," NBER Working Papers 5742, National Bureau of Economic Research, Inc.
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