DP4510 Purchasing Power Parity and the Euro Area

Author(s): Kees Koedijk , Ben Tims , Mathijs A Van Dijk

Publication Date: July 2004

Keyword(s): european integration , real exchange rates , purchasing power parity , heterogenous SUR

JEL(s): F31 , F33 , G15

Programme Areas: International Macroeconomics

Link to this Page: www.cepr.org/pubs/dps/DP4510.asp

This Paper analyses purchasing power parity (PPP) for the euro area. We study the impact of the introduction of the euro in 1999 on the behaviour of real exchange rates. We test the PPP hypothesis for a panel of real exchange rates within the euro area over the period 1973-2003. Our methodology exploits the cross-sectional dependence across real exchange rates and allows for heterogeneity in the rates of mean reversion. We present evidence in favour of PPP for the full panel of real exchange rates, but we show that accounting for cross-country differences within the euro area is essential. The unit root hypothesis can be rejected for some real exchange rates, but evidence for PPP is weak for others. We also investigate PPP between the ‘synthetic’ euro against several other major currencies over the period 1979-2003. We find support for the PPP hypothesis for the full panel of real exchange rates. When the restriction of a common mean reversion coefficient is relaxed, we reject the unit root hypothesis for the euro-Swiss franc rate only. We conclude that the process of economic integration in Europe has accelerated convergence toward PPP within the euro area.