The Real Exchange Rate and the Output Response in Four EU Accession Countries

This paper estimates the response of output to changes in the real exchange rate in four transitional economies. The theoretical effect is ambiguous since the demand-side effect works against the supply-side effect. On the demand-side, a depreciation of the real exchange rate should improve competitiveness and enhance the demand for output, whereas the supply-side effect suggests that output may fall as competitiveness improves since this makes imported inputs more expensive, thereby raising the cost of production. The econometric results show that, inter alia, the real exchange rate is not an important determinant of the long-run level of GDP in the Czech Republic or Hungary, but that a real appreciation leads to a persistent fall in output in Poland and a sustained rise in output in Slovakia. A short run real appreciation leads to a temporary decline in output growth in both the Czech Republic and Slovakia. 2 1. Introduction The relationship between the real exchange rate and the level of output is an important and controversial issue for transitional economies. There are two principal issues: firstly, the level and determinants of the real exchange rate; and secondly, the effects of changes in the real exchange rate on the level of output of the economy. The first issue has been considered for transition economies by Halpern and Wyplosz (1997). They found that, following liberalisation, the real exchange rate usually first depreciates sharply and then appreciates, with the most important determinant of real exchange rate appreciation being increases in labour productivity. The second issue concerning the output effect of real exchange rate movements has yet to be addressed in the context of transition economies, and is the purpose of this paper. 1 The traditional literature suggests that a real exchange rate depreciation will lead to a rise in the demand for domestic output as the gain in competitiveness improves the trade balance, assuming that the sum of the import and export elasticities of demand exceed unity. 2 On the other hand, there are several theoretical reasons why, contrary to the traditional view, devaluation can be contractionary and generate a decline in economic activity. First, a nominal devaluation can result in some contractionary pressures on aggregate demand, which could more than offset the traditional expenditure-switching effect. For example, a devaluation will raise the price level, generating a negative real balance effect (Alexander, 1952), which will, in turn, lower aggregate demand and output. Another …