The effects of competitiveness on trade balance: A case study of Spain

The factors influencing the real exchange rate are an important issue for a country’s price competitiveness. In addition, for a country belonging to a monetary union, such as the Economic and Monetary Union (EMU) of the European Union (EU), the evolution of the real exchange rate reflects inflation differentials vis-à-vis other countries. In this sense, an orthodox account of the economic problems currently experienced by Southern European countries stresses the continuous loss of competitiveness of these countries, due to the higher relative increase in their price levels in previous years as compared to those of Northern Europe. Accordingly, those countries should decrease their wage and prices levels, which would allow them to recover their lost competitiveness. By improving competitiveness, their trade balances would improve, which will translate into a recovery in their levels of activity and employment.

The objective of this paper will be to estimate an econometric model for the trade balance of Spain, a Southern European country that has suffered a prolonged fall in output and employment levels over the last few years. This trade balance equation would depend on the domestic and foreign output levels, as well as on the real effective exchange rate, as a proxy of the country’s competitiveness. The model will be estimated using the ARDL (Autoregressive Distributed Lag) method of Pesaran, Shin and Smith (2001). This method will allow us to obtain simultaneously the current and lagged effects of the different explanatory variables and in particular the real effective exchange rate, so that we may assess whether a J-curve effect exists in the data. The model will be estimated for the trade balance with the world as a whole, as well as with trade with the EU and the euro area.