Generalized Purchasing Power Parity and the Case of the European Union as a Successful Currency Area.

DAVID J. BERNSTEIN [*]

This article uses multicountry purchasing power parity (PPP) tests to study the success of the European monetary system (EMS) in creating a successful currency area for a stable European monetary union. If the EMS has sufficiently integrated the fundamentals within

the European Union, then real exchange rates between member countries will share a common stationary trend when denominated by a common outside currency. Previous research using two-country PPP tests have been inadequate in explaining the nonstationary nature of real exchange rates between the EMS countries and nonmember countries. The use of generalized PPP tests can show that even though individual exchange rates within the EMS may appear to be nonstationary with respect to outside countries, some of them will combine to form a currency union with a stable stationary trend. (JEL F3)

Introduction

In March of 1979, the European monetary system (EMS) formed an exchange rate union (ERU) to establish exchange rate stability in Europe. Membership into the ERU required fixing exchange rates within a narrow band to float jointly relative to the rest of the world. Members of the EMS developed common fiscal and monetary policies toward gross domestic product growth, interest rates, and inflation rates to keep the exchange rates within the band. Common market policies to complement EMS programs were enacted. These policies, allowing for factor mobility, were designed to avoid asymmetric demand shocks within the EMS. These programs and policies culminated in 1991 with the signing of the Maastricht Treaty, an agreement to replace the EMS with a European monetary union (EMU). The precept of the EMU is that after a transitory period, the European Union (EU) member nations would share a common currency, central bank, and a unified monetary policy. [1]

The long-run stability of the EMU depends on the success that the EMS has had in forming a currency area. [2] If the EMS has been successful, then relative purchasing power parity (PPP) between the EU and the rest of the world will exist. Relative PPP is the long-run condition where changes in exchange rates over time are proportional to relative changes in the price levels between countries over the same period of time. Relative PPP for a successful currency area suggests that real exchange rates between member countries are stationary to a long-run mean or a common trend overtime. If they are not stationary, then shocks are never reversed and there will be no reversion to a long-run trend.