The choice of the macro variables included in the specification is motivated by the literature on the key underpinnings of savings and investment imbalances that affect the external current account. At the same time, we acknowledge that the real exchange rate is an endogenous variable, determined jointly with the current account balance (as in the rudimentary open economy model presented in the Annex). Higher expected income growth is expected to reduce savings through consumption smoothing over time, raise investment, and boost imports of goods and services.<sup>9</sup> Per capita income convergence to the average of the Eurozone in a given country (an increase in YGAP) is expected to reduce savings and boost capital inflows to this country. A higher real interest rate is assumed to increase savings, reduce investment, and encourage capital inflows to the country. An appreciation of the real exchange rate reduces competitiveness and is thus expected to lead to lower investment and a larger deficit in the trade balance for goods and services. The current account and the real exchange rate are also affected by other variables, such as -- the dependency ratio, fiscal policies, the terms of trade, foreign demand—but our VAR model focuses on the main determinants debated in the literature, namely, growth, competitiveness and interest rates. Although the VAR model is not a full-fledged model of current account and real exchange rate determination, it is intended to capture some important relationships among these variables and some of their key determinants in a simultaneous equation system.

Our panel includes annual data from 1975 to 2011 for 13 Eurozone countries: Austria, Belgium, Denmark, Finland, France, Germany, The Netherlands and Slovenia for the core group; Greece, Ireland, Italy, Portugal and Spain, for the periphery group.<sup>10, 11</sup> The panel is unbalanced and only becomes highly balanced after the mid-1990s. As we are not focused on the high frequency fluctuations of the current account but rather on the medium-term variations, the use of quarterly data is not considered.

We estimate the multivariate model (1) using the first-differenced Ordinary Least Square (OLS) panel estimator. Since the number of cross-sections is small in our sample (N=13), using the more standard mean-differencing procedure would not be appropriate because the sampling properties of this procedure depend on this number (see e.g. Wooldridge, 2013).<sup>12</sup>

> use indexed-inflation bonds to calculate expected inflation. However, not all the Eurozone countries issue these type bonds.

> 9 We use actual growth as a measure of expected growth, despite the limitations of this assumption, in line with previous studies in the empirical literature of external current account determination (Chinn and Prasad, 2003; Barnes et al., 2010).

> 10 Long term government bonds, the consumer price index series, and the _REER_ series are taken from the IFS database of the IMF. _REER_ series is also complemented with BIS data. _YGAP_ and _GR_ series come from the WDI database of the World Bank. Finally, _CA_ is taken from the BPS database of the IMF.

11 Slovakia adopted the euro in 2009 so consequently we do not include it in the sample. Luxembourg, Cyprus, and Malta are excluded from the panel because of their relatively small economic size and the large size of their financial sector (implying that the dynamics of the current account can be potentially driven by very different factors than for the other members of the Eurozone).

12 Using the first-differenced OLS presents an additional advantage since it highly increases the likelihood of obtaining a stable VAR system.

12