Effective Exchange Rates, Current Accounts and Global Imbalances

Abstract This study analyzes the dynamics between real effective exchange rates and current accounts from a novel perspective. We start by dissecting long‐run and time‐varying short‐run dynamics as well as causalities between both variables. Following this, we extend our framework by including short‐term interest rates. Finally, we examine common exchange rate and current account dynamics across countries based on common factors. Our results show that a real appreciation coincides with a worsening of the current account in most cases. The adjustment pattern is time varying but suggests that the causality mainly runs from effective exchange rates to current accounts. However, an extension of our framework based on monthly data shows that trade balance adjustment is observed less frequently, suggesting that valuation effects play an important role for the relationship between current accounts and exchange rates. From a global point of view, cross‐country trends that drive exchange rates and current accounts also share similar dynamics over the long run, which is an important finding in the context of global imbalances.