Excess volatility of real exchange rates in the EMS: some evidence from structural VARs

Abstract

This paper argues that the effectiveness of the exchange rate mechanism (ERM) of the European Monetary System (EMS) should be gauged by its impact on the monetary component of real exchange rate variability. Nominal and real shocks are separated using a bivariate structural VAR applied to real exchange rate data of the six original member countries participating in the ERM and a control group consisting of Britain and the United States. The findings suggest that monetary shocks have been an important source of real exchange rate variability and that the ERM has been successful in reducing the incidence of monetary shocks across its member countries prior to the EMS currency crises of 1992–93, while being less successful thereafter.