Discussion of "Can appreciation be expansionary? Evidence from the euro area by Philip R. Lane and Livio Stracca"

This paper studies empirically the effects of an appreciation of the real exchange rate. While conventional wisdom suggests that a real appreciation has contractionary effects, this paper emphasizes that a real appreciation works via competing channels and finds that that expansionary effects prevail in EA countries. By using the institutional framework of the EA, the authors identify exogenous shifts in the REER of EA countries. The country-specific REER is instrumented with the NEER interacted with country-specific extra-EA trade shares. Using the Local Projection Method provided by Jorda (2005), the authors construct impulse response functions to REER shocks of a large number of macroeconomic indicators. The key finding is that a REER appreciation is expansionary in EA countries. In particular, the authors find that while net exports decline and unit labour costs rise, real disposable income and consumption rise. Prices eventually rise after an initial contraction, consistently with an expansionary effect. The authors interpret their empirical findings through the lenses of the SOE model in Lombardo and Ravenna (2014). They make clear that REER appreciations impact the economy via two channels with contrasting effects. On one hand, an appreciation of the REER leads to a conventional contractionary expenditure-switching effect: consumption of tradables shifts from domestic to foreign goods. On the other hand, it also leads to a less conventional expansionary terms-of-trade effect: terms of trade become more favourable, relaxing households’ budget constraints by lowering the cost of the consumption basket. It turns out that the expansionary effect prevails over the contractionary one in the EA.