Wednesday, August 1, 2007

How Many Exchange Rates Does a Currency Union Have?

. Wednesday, August 1, 2007

That's a trick question (kind of). But an article in the Spiegel examines the impact of the euro's appreciation against the dollar on German traded goods producers. In a nutshell, German producers seem much less bothered by the appreciation than French producers. Naturally, I wonder why this is so.

Some possibilities:

1. German producers, having lived with the relatively strong mark for fifty years, are accustomed to real exchange rate appreciations. French producers, more accustomed to a stable or soft franc, are not. Hence, German producers cope, French producers whine.

2. The typical German producer earns a larger premium on its exports than the typical French producer. I've been trying to think of what I currently own or covet that is made only in France. Can't think of a single thing (if I had better [any?] fashion sense this might be different). And with all due respect to any foodies who might be reading, Californian wine is a perfectly reasonable substitute for French. In contrast, Germany produces a range of things that I (and many others) quite willingly pay a premium to own. My car is one such example. Thus, German producers can still export at a profit, but earn a smaller premium. French exporters, earning a smaller premium to begin with, have less cushion. Hence, appreciation hurts more.

3. Finally, maybe France and Germany have different real exchange rates. Institutional differences might transform a nominal exchange rate appreciation into very different real exchange rate appreciations. If factor and product markets are inflexible, then a sharp appreciation will not push factor prices down very much. Nominal appreciation thus produces a real appreciation. If markets are more flexible, factor and product prices adjust more quickly, and the nominal appreciation does not have as large of an impact on the real exchange rate. Hence, if institutional structures render French markets less flexible than German markets, the same nominal appreciation might produce a larger real exchange rate appreciation in France than in Germany. Hence, it is not a trick question after all.

I don't know if any of the three hypotheses are right. But the differential response to the same nominal appreciation is a puzzle worth considering. From a political economy perspective, the difference makes it hard for the French to build support in Germany for changes in ECB policy. Can anybody think of other possibilities?


How Many Exchange Rates Does a Currency Union Have?




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