Fiscal imbalances and exchange rate management: Greece on the track of EMU

Abstract

Measured against PPP. the drachma effective exchange rate was overvalued by a significant amount,
implying that the devaluation on March 1998 was an adjustment of the exchange rate towards the
long-run price differentials. The paper also analyses the links between fiscal policy, interest rates and the
real exchange rate in Greece and attempts to empirically measure the forces that push the exchange rate
toward real appreciation. The results suggest that positive shocks to government spending lead to an
appreciation of the temporary component of the real exchange rate. Empirical findings imply that fiscal
adjustment is very important to establishing exchange rate stability.