Persistent global growth differences and euro area adjustment: Real activity, trade and the real exchange rate

Since the launch of the euro, the Euro Area has combined weak growth with persistent trade surpluses, a rising trade share, and the absence of a real exchange rate trend. In academic and policy debates, the Euro Area's trade surplus is often viewed as reflecting weak domestic aggregate demand. This paper argues that a purely demand-based view of the trade balance is incomplete. Using an estimated two-region framework, we find that slower productivity growth in the Euro Area has been a major driver of the trade surplus since 1999, while demand shocks play an important role in the rising trade balance following the global financial crisis. We further show that real exchange rate dynamics cannot be understood from productivity growth differentials and aggregate demand shocks alone, but also reflect longer-run shifts in trade patterns.