Global imbalances, tradeopenness and exchange rate

pass-through

1

Giuseppe Caivano - PhD Candidate Università degli Studi di BariBari, 11 December 2014

Outline of the presentation

• Current Account Imbalances in the EU: the role of tradeopenness

• Current Account Rebalancing and Exchange Rate Adjustment inthe United States

• Estimating pass-through for EU countries: do potentialasymmetries play a role?

2

Current Account Imbalances in the EU: the role of trade openness

SOME STYLIZED FACTS:

Since mid-2000s, most of the academic debate was focused on the United States - where current account deficits continuously deepened-and, on China which kept running substantial current account surpluses.

The EU kept for a long period a substantial balance as a whole. However, recently many states are experiencing growing imbalances.

Surplus: Germany, Sweden, Netherlands

Deficit: Greece, Spain, Portugal

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Source: authors’ elaboration on Eurostat Data

Current account balance in selected European countries

Commercial imbalances softened after the outbreak of the global crisis of 2008-09 but still remained considerably high

4

Another pattern of divergence is associated with the recentsovereign debt crisis that is affecting EU member States. The fiscalpositions of the EU periphery has worsened considerably more than inthe rest of EU countries

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20

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60

80

100

120

140

160

180

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

2011

2012

2013

Debt/GDP

Germany Ireland Greece Spain France Italy Portugal

-10

-5

0

5

10

15

20

25

30

35

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

2011

2012

2013

Deficit/GDP

Core-Periphery: the heterogeneous worsening of fiscal conditions in selected Europeancountries. Source: authors’ elaboration on Eurostat Data 5

Introduction• The goal of the paper is to investigate, employing panel

cointegration technique, the long-run drivers of current accountimbalances in 15 EU member States

• Our results indicate that competitiveness factors strongly affectimbalances in countries with a low trade openness, while theeffects weakens as trade openness increases

• High income countries tend to run surpluses, low-income onesaccumulate deficits (convergence hypothesis)

• Credit sector plays an increasing role after the introduction of thecommon currency-> more integrated financial markets give easieraccess to credit for countries that need to finance possible tradedeficits.

6

Potential drivers of the imbalancesLong-run dynamics of CA imbalances attracted an increasing attentionin the literature (Clarida, 2006; Obstfeld and Rogoff, 1996). Potentialdeterminants of imbalances can be grouped as follows:

i. The income (or convergence) channel and the role of financialflows: increasing financial integration weakens the connectionbetween internal investment and savings (Feldstein and Horioka,1980).

With integrated markets, lower income countries can borrowmore in order to converge towards high income one (Blanchardand Giavazzi 2002, Lane and Pels 2012, Ahearne et al. 2007)

7

Potential drivers of the imbalancesii. The competitiveness channel: A higher real exchange rate makes

tradable goods more expensive with respect to foreign goodsArghyrou and Chortareas (2008) , Blanchard (2007), Belke andDreger (2013).

The pattern documented by these authors is not in line with theconvergence hypothesis, as they argue real exchange rate to bethe most important driver of CA fluctuations

iii. Fiscal policy and government debt: Higher debt and expansionaryfiscal policy can translate into lower domestic savings andcontribute to lower CA balance (Feldstein, 1987).

Ricardian equivalence argument criticize this hypothesis.

8

Potential drivers of the imbalances

Mixed results from empirical studies: Abell (1990), Frankel (2006)and Abbas et al. (2010) in support of these hypothesis

Roubini (2006) and Kim and Roubini (2008) find on the contrarythat as fiscal deficits grow, CA balance improves

Other authors (Blanchard, 2007b and Edwards, 2005) argues thefiscal channel to be insignificant or, at best, secondary inexplaining CA behavior

9

Potential drivers of the imbalances

In the EU context, literature is quite scarce. Belke and Dreger(2013) find a negative correlation between debt and CA balancefor southern EU while Aristovnik and Djuric (2010) find a weakcorrelation and therefore reject the twin deficit hypothesis.

iv. Demographic factors: Countries with a higher old-agedependency ratio can have different saving/investment behavior.

Chinn et al. (2003) find a negative impact of dependency ratios onCA balance.

10

The role of trade opennessTheoretical models show how higher trade openness improves theeconomy’s ability to reorganize production in case of adverse shifts inunit labour productivity and relative prices (Cox 2007, Neary 2009 andNavas and Licandro 2010)

With higher openness, firms face higher competition both in home andforeign markets. Therefore, firms are pushed to improve their coststructure and to be more productive to stay in the market (Chen et al.2009)

As international firms are generally more efficient than purelydomestic ones (Melitz and Ottaviano 2008, Mayer et al. 2001), weexpect than more open economies are more able to face adversechanges in real exchange rate (i.e. rer channel has a smaller impact)

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The role of trade opennessMoreover, as openness is strictly correlated with international capitalintegration, the effect of this channel might be heterogeneousaccording to the level of openness.

More open economies are likely to have (ceteris paribus) better accessto international capital markets. In this economies a bigger creditsector is associated with better CA balance (Russ and Valderrama,2009)

Similarly, also fiscal channel can behave differently according todifferent degree of openness (i.e. we expect it to be stronger for low-openness countries)

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Data and estimation technique

Countries : Austria, Denmark, Belgium and Luxembourg, Finland, France, Germany,Greece, Ireland, Italy, Netherlands, Portugal, Spain, Sweden, United Kingdom. Period:1974-2011

Variable name Description Source

ca Current account balance (% GDP) European

Commission –

AMECO database

rer Real effective exchange rate (unit labor costs, in

log)

Bank of International

Settlements

y Real GDP per capita (in log) AMECO

debt Total government debt (% of GDP, in log) AMECO

dep Old-age dependency ratio (% of working age

population, in log)

AMECO

cred Total domestic credit provided by the banking

sector (% of GDP, in log)

IMF – International

Financial Statistics

Database

13

Data and estimation techniqueGiven the presence of stochastic trends, panel cointegration methodsare used. Panels allow to fully exploit cross-section and time seriesdimension.

PANEL UNIT ROOT TESTING:

CADF test (Cross-sectionally Augmented Dickey Fuller test)

by Pesaran (2007): this test has the advantage to control for crosssection dependencies in heterogenous panels. The usual ADF test isaugmented with cross-section average of the lagged levels and firstdifferences of the individual series.

If null is rejected, at least one panel member is stationary.

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Data and estimation technique

PANEL COINTEGRATION TESTING:To examine cointegration, panel and group mean statistics suggestedby Westerlund (2007) are applied.

The principle is to evaluate the null hypothesis of no cointegration byinferring whether the feedback parameter in a panel error-correctionmodel is equal to zero. In particular, statistics are computed as:

Where αi is the feedback

parameter.

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Data and estimation technique

If null is rejected, cointegration holds for all units in case of the panelstatistics and at least for one individual in the group statistics.

The tests behave asymptotically as standard normal. However, becausecross-section are not independent, critical values are obtained bybootstrap methods (800 replications).

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Data and estimation technique

Finally, we estimate the cointegration vector by using the Pesaran et al. (1999) Pooled Mean Group (PMG) estimator

• This allows to constrain long-run components to be the same across group, relaxing this assumption in the short-run.

• This estimator can be used independently from the integration order of the variables of interests

• Assuming the long-run homogeneity increases the efficiency(provided this hypothesis is true)

•As a robustness check, a comparison with the more general Mean Group (MG) estimator is done by running a Hausmann test

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Estimation results and inferenceThe (long-run) empirical equation on the determinants of current account (im)balances is the following:

where is a country-specific effect, i is the country index and t is the time period. Given the high correlation of dependency ratio with the debt and cred variables, our preferred model specification is:

0 1 2 3 4 5

it i it it it it it itca y rer debt dep cred

0

i

0 1 2 3 4

it i it it it it itca y rer debt cred (2)

(1)

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Summary statistics of the variables employed

Variable Obs Mean Std. Dev. Min Max

rer 532 4.588 0.133 4.236 5.098

ca 532 -0.012 0.066 -.499 .155

debt 532 3.930 0.560 1.816 5.138

dep 532 3.095 0.155 2.728 3.476

y 532 5.325 0.359 4.172 6.016

cred 532 4.251 0.542 2.899 5.447

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We use Annual data from 1974 to 2013. Trade openness is intended as total exports and importsto GDP ratio. Openness data by country: Austria (107.2), Belgium (172.0), Denmark (98.6), Finland(84.2), France (54.7), Germany (83.6), Greece (44.3), Ireland (148.4), Italy (55.8), Luxembourg(285.2), Netherlands (133.5), Portugal (70.7), United Kingdom (57.7), Spain (59.1), Sweden (94.6)

Estimation results and inference

Variable Model specification

includes:

Levels First Differences

ca constant

constant and trend

-0.256 (0.399)

0.175 (0.569)

-5.795 (0.000)***

-4.342 (0.000)***

y constant

constant and trend

-2.557 (0.005)***

-0.303 (0.381)

-7.592 (0.000)***

-8.780 (0.000)***

rer constant

constant and trend

-1.583 (0.057)*

-3.069 (0.001)***

-10.443 (0.000)***

-8.818 (0.000)***

debt constant

constant and trend

-1.018 (0.154)

-1.081 (0.140)

-3.021 (0.001)***

-2.343 (0.010)***

dep constant

constant and trend

1.160 (0.877)

4.171 (1.000)

-1.858 (0.032)**

1.071 (0.858)

cred constant

constant and trend

-0.877 (0.190)

0.358 (0.640)

-5.885 (0.000)***

-5.002 (0.000)***

P-values in parenthesis. ***, ** and * are intended as 1%, 5% and 10% confidence level.

Integration tests for the variables employed in the analysis (levels and first differences. Pesaran(2007)’ methodology)

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Estimation results and inference

Variables Gτ Gα Pτ Pα

ca, y, rer, dep,

debt

-4.616***

(0.000)

1.057

(0.204)

-4.697***

(0.008)

-1.807*

(0.048)

ca, y, rer, cred,

debt

-4.099***

(0.000)

1.608

(0.396)

-5.974***

(0.000)

-1.438*

(0.083)

ca, y, rer, cred,

dep

-4.236***

(0.000)

1.015

(0.189)

-6.036***

(0.004)

-1.050

(0.136)

ca, y, rer, cred,

dep, debt

-4.133***

(0.001)

2.140

(0.408)

-5.216***

(0.010)

0.054

(0.231)

Critical values obtained using bootstrap with 800 replications. P-values in parenthesis. ***, ** and * are

intended as 1%, 5% and 10% confidence level. Lag and lead length chosen with AIC selection criterion.

Cointegration is assumed to hold if the null is rejected for all units in the case of the panel statistics, and at

least for one member in the case of the group mean statistics. The tests are asymptotically normal

distributed, and can account for individual short-run dynamics, trend and slope parameters.

Group mean and panel cointegration tests (Westerlund, 2007)

21

Estimation of the cointegration vector (total sample)

Dependent

variable: ca

Coefficients

rer -.2972***

(.0426)

y -.0217

(.0343)

debt .0558***

(.0138)

cred -.0193*

(.0115)

Hausmann test

Prob > Wald chi20.8353

Sample period: 1974-2011. Standard errors in

parenthesis. ***, ** and * are intended as 1%,

5% and 10% confidence level.

Real exchange rate is the mostimportant determinant of CA imbalances

Income channel appears to be absent

Government debt has a small butpositive effect on trade balance (in contrast with the twin deficit hypothesis)

Credit impact very small and significant only at 10% level.

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Does trade openness matter?

To our knowledge, the analysis on the role played by trade openness((exp+imp)/GDP) has not been performed in previous studies.

Here we split the sample in three sub-groups on the basis of trade openness indicator computed using WTO trade statistics :

Low-openness -> France, Greece, Italy, Spain, UK and Portugal (<70% GDP)

Medium-openness -> Denmark, Finland, Germany and Sweden (from 80% to 110% GDP)

High-openness -> Austria, Belgium/Luxembourg, Ireland, Netherlands (>130% GDP)

Results don’t change significantly if we slightly change the composition of the groups

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Does trade openness matter?Dependent

variable: caHigh

openness

Medium

openness

Low

openness

rer -.0691*

(.0361)

-.18667*

(.1063)

-.4368***

(.1082)

y -.0546***

(.0207)

-.25981

(.1790)

.10709*

(.05764)

debt .0229***

(.0075)

-.0421***

(.0099)

-.0560***

(.0186)

cred .0343***

(.0083)

.08716*

(.0500)

-.0865***

(.0209)

All regressions include a country-specific constant. Standard errors in parenthesis. ***, **

and * are intended as 1%, 5% and 10% confidence level.

RER impact increasesas openness decreases

Countries with a smalltradable sector are more sensitive tocompetitivenesschanges

More open economies can better reorganize production in case of adverseshift in ULC (Cox 2007, Neary 2009 and Navas and Licandro 2010)- Productivity factors (Chen et al. 2009)- Market structure factors: low openness countries exports moreconcentrated in goods where price setting is more constrained and firmscan’t adjust their mark-up

24

Asymmetric effects of CA determinants

Income variable significant (but negative) for high-opennesscountries: higher gdp is associated with a worse CA position. The opposite is true for low-openness States.

Higher debt/gdp ratio associated with higher CA deficits in the lessopen countries

Credit sector negatively correlated with CA balance in low-opennessgroup; on the contrary, is positively correlated in the high-opennessone

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Possible explanations

Rise of emerging economies interactions on EU States: Capital inflows from emerging economies concentrated on EU core countries

Core countries outflows to periphery financed their CA deficits (Chen et al.2013)

China and Eastern EU states increased competition mostly on EU periphery(with a low trade openness) (Chen et al. 2013, Di Mauro et al. 2000) while theyhave been beneficial for Germany and Austria’s exports (Marin, 2010)

These interactions cannot be captured in our regression and can potentiallyexplain the insignificance of some coefficient in the medium openness cluster

Different wealth effects and different possibility to access to creditmarkets can explain the asymmetric credit and debt impact.

In some cases easier credit conditions and housing booms (UK, Spain) loweredthe need for precautionary saving and induced overborrowing

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Possible explanations

In the high-openness cluster, debt is channel positive: higher public savings in countries with a better fiscal balance is offset by smaller private savings. On aggregate, total saving is reduced and this in turn lower CA balance. This doesn’t happen in the low openness cluster

With this consideration in hand, an additional robustness check is doneby curtailing the early years and possibly isolate the disturbancies

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A robustness check with different time periods

Dependent

variable: ca1974-1998 1991-2011 1999-2011

rer -.3410***

(.0583)

-.0652***

(.0247)

.0091

(.0162)

y -.0421

(.0489)

.1633***

(.0323)

.0737***

(.0135)

debt .0689***

(.0185)

.1069***

(.0150)

.0278***

(.0070)

cred .0153

(.0175)

-.0814***

(.0075)

-.0757***

(.0043)All regressions include a country-specific constant. Standard errors in parenthesis. ***, ** and * are intended as 1%, 5% and

10% confidence level.

Importance of real exchange rate weakens in the recentdecades

Income channel insignificant before the introduction of the Euro, while it’s positive and significant afterwards

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A robustness check with different time periods

Increasing importance of financial sector over time -> largerand more integrated financial markets allowed to finance CA deficit.

These results confirms the finding of Ahearne et al. (2007) andBlanchard and Giavazzi (2002) -> higher capital marketsintegration among EU countries allowed countries with a lowergdp per capita to borrow more in order to converge towardsricher countries

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ConclusionsThe role of trade openness appears to be not negligible inexplaining part of the divergence in current account position inthe EU.

Competitiveness factors strongly affects low openness countries,while the effects weakens as openess increases

Convergence and credit channels play an increasing role asfinancial and capital integration increases: low income countriesand with a bigger credit sector are likely to be associated with aworse CA balance.

Debt/gdp ratio has a negative impact for trade balance in case ofmedium and low-openness countries, positive for high-opennessone.

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Current Account Rebalancing and Exchange Rate Adjustment in the

United States

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Current account imbalances in the US

While the US continuously increased their trade deficits, emergingcountries (especially China) increased their surpluses.

According to the excess-saving view (Bernanke 2005), the high levels ofsaving by these countries are said to have contributed to keep lowinterest rates and financed the expenditures in the countries indeficits.

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Current account imbalances in the USThe goal of this work is to assess the potential consequences formacroeconomic variables (i. e. real exchange rate and terms of trade)of a rebalancing.

The focus is essentially concentrated on two main points:

1. The speed of the rebalancing process: in the short run (imperfectpass-through to prices) the exchange rate depreciation can besharp.

2. The role of policy reforms: countries in surplus should concentratetheir efforts to improve the productivity in the non-tradable sectorand reduce the degree of home bias in consumption, countries indeficits should aim to expand the productivity in the traded goodssector.

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Literature review

One of the first papers on this issue is Krugman (1985), in which the author claims US dollar would have required a substantial depreciationto bring US deficits to a sustainable level.

Obstfeld and Rogoff (2000, 2005, 2007) incorporate terms of trade in their analysis and suggest a much stronger depreciation to offset the imbalances

Corsetti et al. (2008): tradables and non-tradables endogenous, account for varietes.

Eichengreen and Rua (2011): US versus China or other countries

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The modelStarting from Obstfeld and Rogoff (2007), we enrich the analysis by addingdifferent shocks to the main parameters in the calibration and discussingwhat happens in the case of an imperfect exchange rate pass-through toprices.

ASSUMPTIONS:

Endowments exogenous for any type of output

Flexible Prices

The U.S. as big country, i. e. shocks can alter terms of trade with respectto the rest of the world

Perfect pass-through in the long run, but imperfect in the short

Home bias in consumption: preferences for home produced goods

Law of one price holds

Central bank seek to stabilize CPI Inflation

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Consumption

Consumption index for home country:

Where γ is the quota of budget spent for tradables and θ is elast. of

substitution among tradables and non-tradables.

Tradables consumption is given by:

With α (>0.5) is the quota spent on home produced goods and η the

elast. of substitution among home and foreign produced goods

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Prices

Consumer price index (for home country) is given by:

With PT as price for tradables and PN for non-tradables. The first iscomposed by prices of home and foreign tradables:

If law of one price for tradable holds, we have , where ε is

nominal exchange rate. It follows that

Terms of trade:

Real exchange rate:

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PPP doesn’t hold in consumption choice among tradables, because ofhome bias. Therefore

Real exchange rate:

Market clearing conditions:

CA balance:

With imperfect pass-through:

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Solving the system

Taking as given (exogenously) C, C*, YH, YF, YN and YN* we can solve forrelative prices and get:

(1)

Hence, substituting for and in equation (1) and rewriting the equations in terms of PHYH and PFYF we have:

(2)

(3)

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Solving the system

(4)

where

And real exchange rate becomes:

(5)

Three of the equation (2-5) are independent, hence we can find asolution for relative prices , terms of trade τ and realexchange rate q.

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The analytical implicationsThe baseline case of letting current account balance (CA) to go to zerocaptures the effects of a simulated shock in the aggregate demand bigenough to take current account imbalances to zero

This approach (used by Obstfeld and Rogoff, 2007) is an usefulbenchmark, although there’s not a specific reason for which deficitshave to go to zero to stabilize US’ external liabilities.

With a positive GDP growth and given the reserve currency role playedby the dollar, the US might persistently run current account deficits ifthey are small enough to be sustainable (Mussa, 2005)

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CalibrationParameter Value Source

CA -0.03 World Bank

i 0.05 OR (2007)

η 2, 3 OR (2007)

θ 0.5, 1, 2 Lane, Milesi-Ferretti (2004)

w 1, 0.5 Goldberg and Knetter (1997)

γ = γ* 0.25 OR (2007), Eichengreen & Rua (2011)

σN = σN* 1 OR (2007), Eichengreen & Rua (2011)

α 0.7 OR (2007)

α* 0.925 OR (2007)

σT= σT* 0.22 OR (2007)

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A negative demand shock

Full Balance Adjustment scenario with different elasticities and 50 percent pass-through

θ η Fall in TOT (%) Real q Depreciation (%)

1 2 18.44 38.44

2 2 18.44 22.86

1 3 11.22 32.02

2 3 11.22 17.48

0.5 2 18.44 77.12

With imperfect pass-through, in the benchmark case of θ=1 and η=2,dollar needs to depreciate of about 38 percent to accomplish therebalancing process.

Because of home-bias in consumption, the fall in aggregate demand hitstronger US tradables than foreign ones, therefore terms of tradedeclines. Also price of home non-tradables falls, causing further dollardepreciation.

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A negative demand shock

Central Bank could also stabilize dollar in order to avoid negative effects due to the sharp fluctuation of the currency. this would cause the relative prices of non-tradable goods to be too high and, ultimately, to increase unemployment in that sector.

After the outbreak of Global Crisis of 2008-09, deficits felt from 6 to 3 percent in 2011 and the dollar depreciated by a smaller amount that what forecasted here.

However, unemployment hit stronger especially non-tradable sector as Mianand Sufi (2012) found.

44

Adjustment to a sustainable level

CA

converges

to (% to

GDP)

Adjustment scenario to a sustainable level (50% pass-through)

θ = 1, η = 2 θ = 2, η = 3

Fall in TOT (%)Real q

Depreciation (%)Fall in TOT (%)

Real q

Depreciation (%)

-2.5 % 3.16 6.42 1.90 2.86

-2.0 % 6.30 12.86 3.78 5.76

-1.5 % 9.38 19.32 5.66 8.66

If we assume that the U.S. can be confident about a future economic growth so that deficits can be sustainable, dollar doesn’t need to sharply depreciate as in the full balance scenario.

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A (home) tradable productivity shock (+20%)

Full Balance Adjustment scenario with an Increase in U.S tradables productivity

(100% pass-through)

θ η Fall in TOT (%) Real q Depreciation (%)

1 2 15.79 11.00

2 2 15.79 10.33

1 3 9.70 5.45

2 3 9.70 5.80

0.5 2 15.79 12.66

Altering all parameters including YH (i.e. σN, σT and f) we can test what happens ifadjustment is achieved while US tradable productivity increases.

if the United States expand their productivity in tradable goods, this would helpto accomplish the rebalancing process with a smaller dollar depreciation-> dollar depreciates by 11 percent only.

Also terms of trade fluctuation is smaller.

46

An increase in foreign productivity

Foreign countries, especially the ones in surplus, can implement policies in order to drive the adjustment process without the danger and the instability due to sharp currency depreciations.

A shock in foreign productivity for tradables can be seen as the increased investments in the infrastructure that increases the supply of exportables.

It is tested a shock in foreign productivity in non-tradable sector as well: we can think of this kind of shock as an innovation in the retailing productivity levels of the emerging economies that start to catch up the levels of the United States

47

An increase in foreign productivityAdjustment scenario with a rise in foreign tradables productivity (Full pass-through)

θ η Fall in TOT (%) Real q Depreciation (%)

1 2 5.18 28.93

2 2 5.18 13.94

1 3 3.10 27.00

2 3 3.10 12.38

0.5 2 5.18 68.15

Adjustment scenario with a rise in foreign non-tradables productivity (Full pass-through)

θ η Fall in TOT (%) Real q Depreciation (%)

1 2 8.92 5.01

2 2 8.92 5.18

1 3 5.42 1.80

2 3 5.42 2.57

0.5 2 8.92 4.74

It is common opinion of analysts that an increase of productivity by emergingcountries can help to reduce the imbalances.

Instead, these results show as this is true only if the an enhanced productivity isconcentrated in non-tradables.

48

A shock in consumption preferences

Full Balance Adjustment scenario with a foreign preference shock

(θ = 1, η = 2)

α* Fall in TOT (%) Real q Depreciation (%)

0.825 -26.08 -11.69

0.875-11.76

0.45

0.925 9.22 19.22

Full Balance Adjustment scenario with a preference shock

(θ = 1, η = 2)

α Fall in TOT (%) Real q Depreciation (%)

0.5 28.09 35.14

0.619.29

27.81

0.7 9.22 19.22

The variation in expenditure patterns matters and have a significant impact on both terms of trade and real exchange rate

A reduction of the home bias in consumption can either make the dollar appreciate or depreciate depending on whether that change has happened outside or within the United States

Countries affected by good market rigidities and financial market imperfections should implement structural reforms towards a greater flexibility

49

Caveats and conclusive remarks

In the case in which current account reversal happens too quickly,consequences for the currency stability can be serious.

Policy implications:

-Higher investment in (non-tradable) productivity for countries experiencingCA surplus can help to achieve a rebalancing process

- Same is true for policy reforms that improve tradables productivity forcountries in deficits

- A change in the preferences that can reduce the home bias in consumptionallows the CA to reduce without sharp currency depreciations

50

Caveats and conclusive remarks

Caveats:

- Relatively simple theoretical structure doesn’t account for the roleplayed by financial markets

- Static setting doesn’t include possible strategic behaviour (forinstance, retaliation and expansionary monetary policy from centralbanks)

- Savers and private investors behaviour (they can start to sell assetsin dollar in case of depreciation expectations)

51

Estimating pass-through for EU countries: potential asymmetries play

a role?

52

Motivation

Understanding how much of the exchange rate variation affectstradable prices is crucial

Existing literature commonly assumes pass-through to price to belinear and symmetric, but recent studies are showing as asymmetriesoften play a non-negligible role.

For imports, the effects on domestic inflation are importantwith respect to monetary policy

For exports, elasticity to exchangerate changes is crucial for

competitiveness issues

53

Campbell (2013) shows as in the case of the US, as real exchange rateappreciation (late 1990s, early 2000s) strongly hit output, investmentsand productivity while, on the contrary a correspondent depreciationdoesn’t have the same effect (hysteresis)

Bussière (2007), analyzing a sample of G7 economies, finds that non-linearities and asymmetries in exchange rate pass-through can’t beignored, although their magnitude varies across States.

54

With respect to CA imbalances, the aim here is to assess whether price rigidities with respect to imports (but more importantly to exports) are present in case of selected EU countries.

To find the elasticity of export prices to exchange rate we can estimate the following (country by country):

ΔExpt = β0 + β1 ΔExpt -1+ β2 Δ ER+ β3 ΔPPIt+(Controls)+ β(non-linear terms)+εX,T

Similarly, for imports:

ΔImpt = α0 + α 1 ΔExpt -1+ α2 Δ ER + α 3 ΔPPIt+(Controls)+ α(non-linear terms)+εI,T

Set of controls can include: dummy variables, oil prices, GDP, etc

55

In order to explore the issue of non-linearities is it possible to addother terms (i.e. exchange rate-squared) and dummy variablesinteracted with exchange rate.

In any case, it is possible to obtain 2 estimates of pass-through:

-Short run: β2 and α2

- Long run: β2 /(1- β1) and α2 /(1- α1)

We expect to find that countries more exposed to change in competitiveness(in our previous chapter Italy, Spain, Portugal) have also a higher degree ofpass-through.

56

Thanks for your attention!

57