website title

Students Zone - Answers to Case Study Questions

CASE STUDY 5.2: REAL EXCHANGE RATES IN THE EURO-ZONE

Why do you think German labour costs grew more slowly over this time period than tose in other European countries?

Answer

During this period German unemployment was at very high levels which encouraged wage moderation. This effect was boosted by the fact that the federal government at this time was a Social Democrat/Green coalition with good links to the trade unions and also perhaps by some of the labour reforms which were brought in by this government. However, relative labour costs do not just depend on money wage levels but also on productivity growth. The other reason why labour costs grew more slowly in Germany than elsewhere was that labour productivity was growing faster there in response to the competitive stimulus resulting from the introduction of the euro.

What do the changes described in the case study imply about the relationship of the nominal exchange rate of the euro to its PPP value? Are the developments in the article consistent with the theory of PPP?

Answer

The theory of (absolute) PPP suggests that real exchange rates should remain constant since that any change in nominal exchange rates should be matched by an opposite change in price levels. In this case the real exchange rate of the euro has risen by 18 percent so the figures are not completely consistent with PPP. However, there does seem to be some movement in the direction predicted by PPP in that the dollar fell by 50 percent in nominal terms against the euro from 2002 to 2005. If prices had remained constant in the euro-zone and in the USA during this period then the value of the real exchange rate would have changed proportionately, but in fact it only rose by 18 percent so the fall in the dollar does seem to have been counter-balanced by higher price rises (actually higher rises in labour costs because that is the date being used here) in the USA than in Europe. So, just as in the results quoted in the text of the chapter, we see some adjustment in the direction of PPP but the adjustment is not as quick or as absolute as the PPP theory predicts. We do not have the data to say whether the euro is now above or below its PPP value. The rise in the real exchange rate could mean one of three things: (a) it was below its PPP value and has now risen up to it (b) it was at or above its PPP value and has now risen further above it (c) it was below its PPP value and has now risen above it. We would need further empirical investigation to decide between these three possibilities.

On the basis of what happened to the real exhange rate of the euro over the time period described in the case study, what would you expect to have happened to the nominal value of the euro from spring 2005 onwards? Do your predictions coincide with what did actually happen?

Answer

The rise in the real exchange rate for the euro indicates a worsening of competitiveness for European business so, unless labour costs continued to decline sharply in Europe relative to elsewhere, we would expect to see the nominal value of the euro stabilise or even decrease as European companies faced increasing pressure in world markets. In fact the euro did drop against the dollar during 2005 and 2006 indicating that perhaps it had overshot its PPP value in the earlier rise and needed to adjust back. The problem with this in global terms was that the decline in the value of the euro during this period did not help the USA to reduce its record deficit on the current account of the balance of payments.

Other chapter answers >>

website title

Site Links

Lecturers Zone

Students Zone

Other