What drives movements in the REER of the SEE countries? A decomposition approach

Abstract

The real effective exchange rate (REER) is an important indicator for researchers and policymakers that contains valuable information about a country's competitiveness and economic performance. Despite the numerous literature that deals with the analysis of exchange rates, there are very few analyzes of the main drivers of REER changes, especially when it comes to transition economies. To fill this gap, we analyze the shifting patterns observed in the REER movement in the countries of Southeast Europe (SEE). By using a new approach in the literature that enables the decomposition of REER changes, we aim to explore the underlying driving forces behind REER changes, which is particularly significant in the light of current global instability. The results show large variations across eight countries from the SEE region and through time since the beginning of the 21st century. The entire observed period can be generally characterized as a period of real appreciation of the currencies of most of the analyzed countries, which indicates the deterioration of their international competitiveness in the period from January 2001 to December 2020. Analysis of the drivers of the REER changes, using two approaches, showed that short-run REER changes are dominated by the nominal effective exchange rate (NEER) changes, in most of the analyzed countries. Although the contribution of price changes (domestic and foreign) is lower than the contribution of the NEER changes, it cannot be concluded that the inflation differential contributes little, and by no means negligible, to the REER changes. This result indicates the necessary caution of the SEE countries in the context of current price instabilities.