What Determines European Real Exchange Rates?

We study a newly constructed panel data set of relative prices of a large number of consumer goods among 31 European countries. We find that there is a substantial and non-diminishing deviation from PPP at all levels of aggregation, even among eurozone members. However, real exchange rates are very closely tied to relative GDP per capita within Europe, both across countries and over time. This relationship is highly robust at all levels of aggregation. We construct a simple two-sector endowment economy model of real exchange rate determination. Simulating the model using the historical relative GDP per capita for each country, we find that for most (but not all) countries there is a very close fit between the actual and simulated real exchange rate.