External rebalancing is not just an exporters’ story: real exchange rates, the non-tradable sector and the euro

Global and European trade balances have seen strong divergences combined with strong movements in the exchange rate. Trade balances and real effective exchange rates are related.

Using different measures of the real effective exchange rate, we show that this long-run link hinges on the relative price of non-tradable to tradable goods and services in relation to their trading partners. An improvement in the trade balance is associated with a fall in the relative price of non-tradable goods and services. The elimination of nominal exchange rates with the euro does not change these relationships. Government consumption increases the relative price of non-tradable goods.

The results highlight the importance of internal price adjustments for external balances, a point frequently overlooked in policy debates.