PURCHASING POWER PARITY IN THE MAJOR EMS COUNTRIES - THE ROLE OF PRICE AND EXCHANGE-RATE ADJUSTMENT

In this paper we address the issue of whether the European Monetary System has contributed to real exchange rate stability between France, Germany, and Italy. We first ask whether bilateral PPP holds between any pair of these countries and between each of them and the United States. We find that PPP never holds before the EMS was created, and that it does among EMS countries, but not relative to the U.S. since. Next we assess the role of relative prices and exchange rates in the adjustment process toward PPP. We find that PPP between France and Germany is solely due to exchange rate dynamics. However, both nominal exchange rate and domestic inflation rate changes are responsible for the emergence of a PPP relationship between Italy and Germany, though price movements contribute less than nominal exchange rates to the adjustment process.