Common Trends and Cycles in European Industrial Production: Exchange Rate Regimes and Economic Convergence

Abstract

We analyse monthly data on six European industrial production series to ascertain the presence of common cycles and trends. Particular attention is paid to the exchange rate regime, with the Bretton Woods and Exchange Rate Mechanism (ERM) regimes being analysed separately. We employ recently developed techniques in vector autoregressive (VAR) modelling (a) to test for and estimate both common trends and common cycles, (b) to estimate VAR models subject to these ‘common feature’ restrictions, (c) to compare and contrast these models with those obtained from an alternative approach, that of estimating unrestricted levels VAR models, and (d) to present a permanent–transitory decomposition of the series that is based on the common trends found in the systems. We find limited evidence of convergence during the ERM, and this is of a long‐run nature. In the short run, asymmetric shocks seem to have produced a divergence compared with the earlier Bretton Woods regime. There is also some evidence of German ‘leadership’ over Belgium, France and the Netherlands.