Sustainable Exchange Rates When Trade Winds Are Plentiful

Abstract

Estimation and simulation of sustainable real exchange rates in a sample of EU member countries find vulnerabilities connected to the adoption of the euro if the rate vis-à-vis the euro were to be fixed with weak fundamentals and inappropriate policies. Sample countries have benefited from dramatic improvements in their external positions, in part driven by inflows of foreign direct investment. As a result, exchange rate misalignments have narrowed in most countries and, looking ahead, are expected to narrow further. These results are conditional, however, on optimistic projections with respect to world import demand and foreign direct investment inflows.