Policy convergence, the exchange rate mechanism and the misalignment of exchange rates. Some tests of purchasing power parity and generalized purchasing power parity

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Abstract
The paper focuses on the convergence issues and the long-run credibility of the European Monetary System (EMS), and, more specifically, on the evaluation of the effectiveness of the Exchange Rate Mechanism (ERM) in generating a stabilizing effect on real exchange rates across member countries. For this purpose, we execute some tests of long-run purchasing power parity (PPP) for an ERM group and a non-ERM group of countries using both the Engle and Granger procedure and the more powerful Johansen cointegration technique. We also execute a test of Generalized PPP, exploiting an idea developed by Enders and Hurn. Testing for PPP in a multicountry setting may be a useful methodology to identify the optimal currency area suggested by the data generation process, on the basis of the reported homogeneity of real exchange rate behaviour of the countries considered.

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