Rethinking exchange rate effects on trade balances: evidence from the European Union

Purpose The purpose of this study is to investigate whether movements in the real effective exchange rate (REER) affect trade balance dynamics in EU economies after explicitly controlling for domestic absorption. Design/methodology/approach Using annual panel data for 20 EU countries from 2000 to 2024, the analysis uses fixed-effects and dynamic system Generalized Method of Moments estimators within elasticity- and absorption-based adjustment frameworks. Findings REER appreciations and depreciations have no statistically significant effect on trade balances. In contrast, domestic absorption – particularly consumption and investment – exerts large and robust negative effects. Inflation shows a weak but consistently adverse influence, while structural features condition any potential price-based adjustment. Research limitations/implications The use of aggregate panel data may mask country- or sector-specific adjustment mechanisms and heterogeneous structural shocks. Practical implications External adjustment policies in the EU should prioritize domestic demand management, structural competitiveness and inflation discipline rather than relying on REER movements. Originality/value This study provides strong evidence against the empirical relevance of exchange-rate-led adjustment in a highly integrated monetary union, emphasizing demand-side and structural drivers of external balances.