Conditional PPP and Real Exchange Rate Convergence in the Euro Area

Paul Bergin, Reuven Glick and Jyh-Lin Wu

No 21979, NBER Working Papers from National Bureau of Economic Research, Inc

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.

JEL-codes: F0 F15 F31 (search for similar items in EconPapers)
Date: 2016-02
New Economics Papers: this item is included in nep-cba and nep-eec
Note: IFM
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Published as Bergin, Paul R. & Glick, Reuven & Wu, Jyh-Lin, 2017. "“Conditional PPP” and real exchange rate convergence in the euro area," Journal of International Money and Finance, Elsevier, vol. 73(PA), pages 78-92.

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Journal Article: “Conditional PPP” and real exchange rate convergence in the euro area (2017)
Working Paper: “Conditional PPP” and Real Exchange Rate Convergence in the Euro Area (2016)
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