SFB 303 Discussion Paper No. B - 420
Author: Weber, Axel A.
Title: Sources of Purchasing Power Disparities: Europe Versus the United
Abstract: In order to design appropriate exchange rate policies, it is instrumental to understand the sources of real and nominal exchange rate movements. We apply and extend the structural vector autoregressive (SVAR) model of Clarida and Galí (1994) in order to identify the importance of various types of real shocks (labour supply, aggregate supply and aggregate demand) and nominal shocks (money demand and money supply) for European and transatlantic exchange rate movements. It is found that whilst real and nominal U.S. dollar exchange rates are driven predominantly by relative demand shocks, European real and nominal exchange rate movements have distinctly different roots. The bulk of European relative price and nominal exchange rate movements can be explained by the differential long-run impact of monetary policy, and moving to EMU will eliminate both. However, misaligments are likely to persist between the Euro-area and the economies outside the Union. It is argued that for these fringe currencies the pegging the exchange rate vis-a-vis the Euro has to be supplemented by special institutional arrangements (formal policy coordination or a currency board) in order to avoid potentially destabilizing asymmetric monetary policy shocks.
Keywords: purchasing power parity, exchange rates, shocks, structural vector autoregression, impulse response functions, variance decompositions
JEL-Classification-Number: F0, F3
Creation-Date: November 1997
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