Real Variables, Nonlinearity, and European Real Exchange Rates

We carry out an analysis of European real exchange rate behavior before and after the implementation of Economic and Monetary Union (EMU). In particular, we model real exchange rates for a number of EMU and non-EMU countries against Germany in an explicitly nonlinear framework and allow for variation in the equilibrium level of the long-run equilibrium real exchange rate using either relative productivities or real diffusion indices. We find strong evidence of nonlinear adjustment, and the estimated models show that real variables are a significant determinant of long-run real exchange rates when incorporated into a nonlinear framework for half of the countries examined. We also find that the speed of adjustment is generally faster after the implementation of EMU.