Capital Inflows and Costs: The Role of the Euro

The changing environment that the Euro has brought to its member countries could have fuelled the deteriorating effect that net capital inflows potentially have on their cost competitiveness. This paper uses a difference-in-differences (DID) approach to assess the effect of the Euro on the relationship between capital inflows, as measured by current account imbalances, and unit labour costs over the period 1993-2007. The sample used consists of annual data for 24 developed economies, comprising both the first EA12 countries as well as non-EA countries, with the latter used as the comparison group in the analysis. We find that the Euro seems to have amplified the deteriorating effect of capital inflows on costs. This finding suggests that the Eurozone should monitor cumulative current account imbalances, the associated inflows of capital, and the potential vulnerability of each country to the detrimental effects that capital inflows may have on their economies.