Sources of Real Exchange Rate Fluctuations in Central and Eastern Europe – Temporary or Permanent?

This paper investigates, using the SVAR model of Clarida and Gali (1994), the sources of real exchange rate fluctuations in eight Central and East European new EU member states. Theoretically, one should expect the real exchange rates of Exchange Rate Mechanism II participants to be primarily driven by temporary shocks and those of ERM II “outs” by permanent shocks. Our results reveal an opposite pattern. We conclude that the sources of real exchange rate movements – and the usefulness of nominal exchange rates as shock absorbing instruments – were not the decisive factor behind these countries’ decisions concerning the ERM II participation.