Policy convergence, the exchange rate mechanism and the misalignment of exchange rates. Some tests of purchasing power parity and generalized purchasing power parity

Abstract

The paper focuses on the convergence issues and the long-run credibility of the European Monetary System (EMS), and, more specifically, on the evaluation of the effectiveness of the Exchange Rate Mechanism (ERM) in generating a stabilizing effect on real exchange rates across member countries. For this purpose, we execute some tests of long-run purchasing power parity (PPP) for an ERM group and a non-ERM group of countries using both the Engle and Granger procedure and the more powerful Johansen cointegration technique. We also execute a test of Generalized PPP, exploiting an idea developed by Enders and Hurn. Testing for PPP in a multicountry setting may be a useful methodology to identify the optimal currency area suggested by the data generation process, on the basis of the reported homogeneity of real exchange rate behaviour of the countries considered.