On May 4, 2016, the New York Times printed an article by Paul Krugman in which he posited his opinion on Real Exchange Rates and European Adjustment. The author pondered initially what the correlation between real exchange rates and trade adjustment would look like. His question arises from common criticism he hears, that devaluation of the local currency either has not worked or is not needed. Krugman then shows a graph (see Appendix) which clearly displays that Ireland, Greece, Portugal and Spain (countries that have experienced currency devaluation) have experienced a higher change in the current account than European countries that have not made such adjustments. The author concedes that some of this relationship may be linked to other factors (such as a decrease in imports), but likely the correlation is due to increased competitiveness. He finishes his articles stating that “the raw correlation between real exchange rates and trade adjustment is much stronger than I thought, and probably than most people think” (Krugman, P., 2016, May 4)
Krugman, P. R., Obstfeld, M., & Melitz, M. J. (2015) describe in their book the effects of currency depreciation. A depreciated currency turns imports into more expensive and makes domestically produced goods and exports less expensive, i.e., more competitive in the international market. Hence, a devalued currency tends to increase a country’s exports and its current accounts (as referred to in the article).
A natural question arises: if the graph Krugman showed in the article (see Appendix) was only comprised of nations in the Eurozone – all of them share the same currency, the Euro – how come were there different devaluations? The answer lies on inflation. As inflation increased in Ireland, Greece, Portugal and Spain above the other Eurozone countries, their real effective exchange rate showed a currency devaluation. For example, prices in Portugal became lower than in Germany, then there was a strong tendency for the increase of Portugal exports to Germany. Portugal exports became more competitive and, consequently, Portugal’s current account grew positive.
References
Krugman, P. (2016, May 4). Real Exchange Rates and European Adjustment. Retrieved May
29, 2016, from http://krugman.blogs.nytimes.com/2016/05/04/real-exchange-rates-
and-european-adjustment/?_r=0
Krugman, P. R., Obstfeld, M., & Melitz, M. J. (2015). International Economics: Theory and
Policy. Boston: Pearson.
Appendix
