Aggregate and sector-specific exchange rate indexes for the Portuguese economy

Economic theory and empirical evidence suggest that fluctuations in exchange rates may have strong reallocation effects. Accession to the Exchange Rate Mechanism in 1992, and then to the European Monetary Union in 1999, implied a drastic change in the behaviour of Portugal's exchange rate indexes. The analysis of those indexes is therefore bound to play an important role in the study of the evolution of the Portuguese economy in the last two decades. However, there are many alternative exchange rate indexes. In this paper, we compute and compare aggregate and sector-specific exchange rate indexes for the Portuguese economy. We find that alternative effective exchange rate indexes are very similar between them. We also find that sector-specific effective exchange rates are strongly correlated with aggregate indexes. Nevertheless, we show that sector-specific exchange rates are more informative than aggregate exchange rates in explaining changes in employment: whereas aggregate indexes are statistically insignificant in employment equations, regressions using sector-specific exchange rate indexes show a statistically significant and economically large effect of exchange rates on employment.