Sources of Real Exchange Rate Variability in Central and Eastern European Countries Evidence from Structural Bayesian MSH-VAR Models

Abstract

This paper investigates the relative importance of cost, demand, financial
and monetary shocks in driving real exchange rates in four CEE countries over
2000–2018. A two-country New Keynesian open economy model is used as a
theoretical framework. In the empirical part, a Bayesian SVAR model with
Markov switching heteroscedasticity is employed. The structural shocks are
identified on the basis of volatility changes and named with reference to the sign
restrictions derived from the economic model. Main findings are fourfold. First,
real and financial shocks have similar contributions to real exchange variability,
whereas that of monetary shocks is small. Second, financial shocks amplify
exchange rate fluctuations stemming from real shocks. Third, even though the
exchange rate gaps change over time, they remain quite similar across CEE
countries except for Slovakia. Fourth, Slovakia introduced the euro at the time
of a relatively large real overvaluation, which subsided after a lengthy adjustment
process.