Exchange rate misalignment and nonlinear convergence to purchasing power parity in the European exchange rate mechanism

Abstract

In the wake of recent contributions, a nonlinear adjustment to purchasing power parity is explored over the real exchange rates of two key European currencies with respect to the German Mark: the Italian Lira and the French Franc. The periods considered in the estimation range from the demise of the Bretton Woods system to the crisis of the European Exchange Rate Mechanism. The estimation results lend support to a growing literature both theoretical and empirical that has suggested that significant nonlinearities may be present in exchange rate series. This finding is also important for the internal consistency of the ERM.