Do Changes in the Real Exchange Rate Affect the Trade Balance? Evidence from European Countries

Abstract We use time and frequency domain causality tests to study whether unit-labor-costs-based real exchange rate depreciations/appreciations caused improvements/deteriorations in the trade balances of ten Eurozone economies, and thus contributed to closing trade imbalances, during 1995–2019. The methods we use deal with the inherent nonlinearity and structural shifts in the time series. They also consider asymmetry and regime changes. The non-parametric approach avoids the possible bias associated to the identification strategy. Test results indicate that, for most countries, exchange rate movements do not cause the trade balance dynamics. Hence, policy strategies solely focused on exchange rate adjustments may not be enough to overcome trade imbalances.