Conditional PPP and Real Exchange Rate Convergence in the Euro Area

31 Pages Posted: 15 Feb 2016

See all articles by Paul R. Bergin

Paul R. Bergin

University of California, Davis - Department of Economics; National Bureau of Economic Research (NBER)

Reuven Glick

Federal Reserve Bank of San Francisco - Center for Pacific Basin Monetary & Economic Studies

Jyh-Lin Wu

National Sun Yat-sen University; National Chung Cheng University - Department of Economics

Date Written: February 2016

Abstract

While economic theory highlights the usefulness of flexible exchange rates in promoting adjustment in international relative prices, flexible exchange rates also can be a source of destabilizing shocks. We find that when countries joining the euro currency union abandoned their national exchange rates, the adjustment of real exchange rates toward purchasing power parity (PPP) became faster. To disentangle the possible causes for this finding we develop a novel methodology for conducting counterfactual simulations of an estimated VECM that distinguishes between the roles of the nominal exchange rate as an adjustment mechanism and as a source of shocks. We find evidence that prior to joining the euro currency union, member countries relied upon exchange rate adjustments as a mechanism to correct for PPP deviations arising from divergent domestic inflation rates. But the loss of the exchange rate as an adjustment mechanism after the introduction of the euro was more than compensated by the elimination of the exchange rate as a source of shocks, in combination with faster adjustment in national price indices. These findings support claims that flexible exchange rates are not necessary to promote long-run international relative price adjustment.

Suggested Citation

Bergin, Paul R. and Glick, Reuven and Wu, Jyh-Lin, Conditional PPP and Real Exchange Rate Convergence in the Euro Area (February 2016). NBER Working Paper No. w21979. Available at SSRN: https://ssrn.com/abstract=2732456

Paul R. Bergin (Contact Author)

University of California, Davis - Department of Economics ( email )

One Shields Drive
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Davis, CA 95616-8578
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530-752-8398 (Phone)
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National Bureau of Economic Research (NBER)

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Reuven Glick

Federal Reserve Bank of San Francisco - Center for Pacific Basin Monetary & Economic Studies ( email )

101 Market Street
San Francisco, CA 94105
United States
415-974-3184 (Phone)
415-974-2168 (Fax)

Jyh-Lin Wu

National Sun Yat-sen University ( email )

70 Lien-hai Rd.
Kaohsiung 80424, 80743
Taiwan

National Chung Cheng University - Department of Economics

168 Univeristy Road
Ming-Hsiung, Chia-Yi, Taiwan 621
Taiwan

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