Relative Purchasing Power Parity and the European Monetary Union: Evidence from Eastern Europe

By Findreng, Jon Håkon | Economics & Sociology, January 1, 2014 | Go to article overview

Relative Purchasing Power Parity and the European Monetary Union: Evidence from Eastern Europe


Findreng, Jon Håkon, Economics & Sociology


(ProQuest: ... denotes formulae omitted.)

Introduction

There is today a wide discussion in Europe concerning which countries to include in the European Monetary Union (EMU) and how these countries (and the EMU itself) will benefit from a membership. Schadler, Drummon, Kuijs, Murgasova and Elkan (2005) argue that, for countries adopting the Euro, the trade-off is between gain in trade and growth and increased volatility as a result of losing the exchange rate as a shock absorber. Further they conclude that for central European countries (CEC), an adoption of the Euro will hasten real convergence and will at most suffer a modest increase in volatility. The basic question comes down to: when and how to adopt the Euro (Schadler, Drummond, Kuijs, Murgasova, & Elkan, 2005).

One deterministic factor for the loss of increased volatility is the optimum currency area (OCA) criteria. The OCA captures the sensitiveness of a country's economy to real shocks that are asymmetric to those in the currency union. The OCA therefore measures how often the Euro-area monetary policy is likely to be different from the monetary policy necessary for the potential incoming country. In other words, the OCA measures whether the economic cycles in the Euro-area and the economic cycles in the potential EMU-client are synchronized. The OCA criteria also focus on how well the potential client can adopt to shocks without their own monetary policy (Schadler, Drummond, Kuijs, Murgasova, & Elkan, 2005).

This paper discusses relative purchasing power parity (PPP) in some of the countries in the Balkan area versus Germany, which is the largest economy in the EMU. Findings that suggest that PPP holds do not automatically suggest that OCA criteria are fulfilled and that the economies are synchronized. However, positive finding in regards of PPP implies that the real exchange rates share common trends and are driven by economic fundamentals. Thus, positive findings of PPP suggest that the analyzed country is suitable to adopt the euro regarding the terms discussed above (Caporale, Ciferri, & Girardi, 2008). The countries examined in this paper are Albania, Bulgaria, Croatia, FYR Macedonia, Romania and Turkey.

Purchasing Power Parity

PPP is the simple idea that arbitrage enforces national price levels to be equal after converted to the same currency (Rogoff, 1996). Rogoff (1996) writes that most economists believe that PPP is a long term anchor for real exchange rates; however, few take PPP seriously as a short term proposition. There are several variants of PPP.

The Law of one Price

The strictest version of PPP is the law of one price (LOP). The LOP states that after converting prices to one common currency, any good should have the same price across countries. The LOP can be expressed as:

...

Where Pi is the domestic price of good i, E is the nominal exchange rate (expressed as the price of one unit foreign currency in domestic currency) and is the foreign price of good i (Rogoff, 1996). Even though some internationally traded goods with default standards such as oil, gold, silver and sugar have the same price regardless of the country, it does not take much imagination to come up with examples that violates the LOP. Rogoff (1996) argues that tariffs, transportation costs, and nontariff barriers make the prices differ.

Absolute Purchasing Power

Absolute PPP requires that after converting prices to one common currency, the sum of prices over a consumer price index should be the same across countries. Absolute purchasing power can be expressed as:

...

There are several issues related to measuring absolute PPP. Firstly, it is not clear what consumer price index to use. Consumer price indices might vary in different countries. The indices are not only likely to be different by origin, but goods are introduced and taken away as well as consumption weights are shifting. Governments do not follow an internationalized standard index. …

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