ABSTRACT
1.                  Title: Purchasing Power Parity in the EU: A Cointegration Approach on Developed and Transition Economies
2.                  Objectives: To assess the suitability of forthcoming euro area entrants from former central and eastern Europe (plus the UK, Denmark, and Sweden) through an analysis of the nominal exchange rate and relative price dynamic vis-á-vis the current euro area.  Does cross exchange rate arbitrage affect the results (i.e. using the euro as the numeraire currency as opposed to the US dollar?). Do capital flows appear to be important as a driver of exchange rate fluctuation for the transition and developed economies in the sample?.
3.                  Data/Methods: Using monthly data (euro nominal exchange rate, domestic CPI, foreign (euro area) CPI) for 15 EU countries not in the euro area, I use multivariate and panel cointegration procedures for the period since the introduction of the euro (1999M1-2007M3).  Thus, 15 tri-variate VARs are specified for each country across the three variables.  Using Johansen cointegration tests across the tri-variate VARs, I firstly examine whether a long-run equilibrium can be identified.  Then, by imposing restrictions on cointegrating vectors identified, I can determine the validity of PPP.  The panel element is based on the approach of Larsson et al (2001). 
4.                  Results/Expected Results: Preliminary results suggest that long-run PPP holds in 10 cases and domestic prices or the nominal exchange rate are the main driver of the short-run adjustment to stationarity.  PPP should be validated in cases where the transition economy in question operates a fixed exchange rate regime with the euro area.  Domestic prices should drive the convergence process in these cases.  Where a floating regime exists, with inflation as the nominal anchor, any convergence of PPP found should be driven by the exchange rate.  Where PPP fails, what does this imply? Should Balassa-Samuelson effects be taken into account? Is the exchange rate driven more by capital flows than trade flows?
5.                  Conclusions: This paper has important implications for the suitability of forthcoming euro area members.  A failure of PPP could indicate a lack of suitability if the failure of traditional PPP cannot be sufficiently explained (e.g. perhaps capital flows have become more dominant than trade flows in driving convergence and therefore any such model of the exchange rate must incorporate not only relative prices, but also relative interest rates).