Explaining Exchange Rate Movements in New Member States of the European Union: Nominal and Real Convergence

Abstract

This paper uses the univariate and bivariate structural VAR variance framework to quantify real and nominal exchange rate volatility in the selective New Member States of the European Union, and identify factors responsible for movements of those rates. The scale and the nature of nominal and real exchange rate volatility are tightly linked to fulfilment of Maastricht criteria, real convergence, and the effectiveness of the nominal exchange rate in absorbing asymmetric real shocks. Given that there is no consensus on the appropriate definition of real convergence, and since the degree of real exchange rate volatility reflects the scale of idiosyncratic shocks, as well as overall flexibility of the economy to adjust to these shocks, this paper measures the degree of real convergence by the degree of real exchange rate variability. The results indicate that (i) real asymmetric shocks are not insignificant when compared with the poorer Old Member States of the European Union (ii) the nominal exchange rates, in general, do play a stabilising role, and that (iii) nominal shocks, on average, do not move real exchange rates. Therefore, based on the analysis conducted in this paper, it appears that among the New Member States, only Estonia and Slovenia are ready to give up monetary and exchange rate independenceExchange Rate Volatility, Convergence, European Monetary Integration, Structural Vector Autoregression, Heteroskedasticity, Small-sample Confidence Intervals