Exchange rate and macroeconomic adjustment in southern eurozone countries

• Published in: Economic systems Vol. 41; no. 4; pp. 639 - 650
• Main Authors: García-Solanes, José, Torrejón-Flores, Fernando, Ródenas-Monedero, Irene
• Format: Journal Article
• Language: English
• Published: Elsevier B.V 01.12.2017
• Subjects: Cross-sectional dependence; Panel cointegration and VEC models; Penn effect; Real exchange-rate misalignment; Panel cointegration and VEC models; F41; F32; Penn effect; F36; Cross-sectional dependence; Real exchange-rate misalignment
• ISSN: 0939-3625; 1878-5433
• DOI: 10.1016/j.ecosys.2016.12.006

•Two econometric tests are applied to uncover the need to adjust the exchange rate in four Southern European countries.•We investigate the relationships between the nominal exchange rate and other macroeconomic variables.•We estimate a Penn-effect equation enlarged with net foreign assets, and address the issue of cross-sectional dependence.•We use data over a long period governed by several exchange rate regimes, including the EMS and participation in the euro.•Policy prescriptions are derived concerning the participation of the four countries in the euro. In this paper, we estimate panel cointegration and VEC models to show that, during the pre-euro period, devaluation and/or depreciation of the domestic currency were a recurrent weapon for macroeconomic adjustment in Greece, Italy, Spain and Portugal. Moreover, we perform panel Penn-effect regressions using a sample of 114 countries to prove that during the period 1970–2011 the four countries incurred misalignments of remarkable size and variability in their real exchange rates. All in all, our results reveal that for several decades the four countries needed to use their nominal exchange rate as a tool of macroeconomic adjustment. Since variations of the nominal exchange rate within the EMU are no longer an option, the four southern eurozone countries should accomplish the necessary structural reforms to avoid new and painful internal devaluations in the coming years.