Short and long run effects of exchange rate movements on the trade balance: a Eurozone perspective

The purpose of this paper is to examine the short and long run relationship between the real effective exchange rate (REER) and the trade balance of 12 Eurozone countries. Panel data is used and countries are also analysed separately. Using the autoregressive distributed lag (ARDL) model in error correction form, we investigate whether a depreciation of the euro and other determinants have an effect on the trade balance. Theory suggests a depreciation has a positive effect on the trade balance, at least in the long run. Using this approach, we do not find a significant short run relationship between the two variables which has also not been found in many other studies. In the long run a small positive relationship is found between the REER and the trade balance which corresponds to a negative effect of a depreciation on the trade balance. This is in contradiction with standard macroeconomic theory.