Are the baltic counties ready to adopt the euro? a generalized purchasing power parity approach

Abstract

This paper analyses macroeconomic interdependencies between the Euro area and three transition economies (Estonia, Lithuania and Latvia), and whether the latter are ready to adopt the Euro. The theoretical framework is based on the generalized purchasing power parity hypothesis, which is empirically tested within a vector error correction model. Using monthly observations over the period 1993-2005, it is found that the generalized purchasing power parity hypothesis holds for the real exchange rate vis-à-vis the Euro of each Baltic country, reflecting a degree of real convergence consistent with optimum currency area criteria. Further, the chosen model outperforms alternative ones in terms of out-of-sample forecasts. © 2011 The Authors. The Manchester School © 2011 Blackwell Publishing Ltd and The University of Manchester.