, Volume 18, Issue 3, pp 417-429

Exchange rate dynamics and currency unification: The Ostmark-DM rate

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Abstract

This paper estimates a simple model of the exchange rate between the East and West German Mark immediately preceding German monetary union. Although there is a theoretical literature on exchange rate dynamics when the introduction of a fixed exchange rate is anticipated, the absence of data has limited empirical work on the subject. We show that in the first part of the sample, the DM-Ostmark exchange rate behaves as a random walk. In the second half, when monetary union appeared more likely, the exchange rate behaves as a weighted average of fundamentals and the expected “terminal” exchange rate.

This research was supported by grants from INSEAD's Research Department (Burda), and Bankforskningsinstitutet and the Center for International and Comparative Studies at Brandeis (Gerlach). We thank Susan Collins, Salih Neftçi, Charles Wyplosz and seminar participants at INSEAD, the Graduate Institute of International Studies (Geneva), and Harvard for useful comments and Dean Drysdale for help in collecting the data.