The purchasing power parity hypothesis in Europe
One of the big issues in the debate over the euro is whether Europe is an optimal currency area, that is, whether prices in Europe move sufficiently closely together to make a common monetary policy a reasonable idea. Looking at the issue when the move to the euro was agreed most observers would have said that Europe wasn’t an optimal currency area. A plausible counterargument is that monetary union will produce the kind of economic integration required. A quick scan of the web didn’t turn up much, so I thought I’d do a quick and rough check of my own, so I World Economic Outlook Database, which gives, among lots of other useful things, estimates of purchasing-power-parity adjusted exchange rates for all the countries in the data set. Since the calculations are based on the EU-centric international comparisons project, comparisons of relative price levels between EU countries should be pretty good.
So I looked at the log variance of the $US PPP exchange rate for the euro-12 countries from 1995 to 2005 and here’s what I got
The log variance is a measure of the extent to which real price levels differ and, as the chart shows it has declined smoothly since the beginnings of the move to the euro.
Another interesting feature of the data is the average PPP exchange rate is around $US1.16 to the euro, very close to the rate that actually prevails.
fn1. I found one study by Robert Hill of UNSW, but it only went up to 2000 and covered the whole EU not just the eurozone. Hill found some convergence in price levels, but not as strong as this, but a surprising divergence in relative prices. It would be interesting to check on this.