Virtual and Composite Fundamentals in the ERM.

A latent-variable approach is applied to identify the appropriate driving process for fundamental exchange rates in the ERM. From the time-series characteristics of so-called 'virtual fundamentals' and 'composite fundamentals,' a significant degree of mean reversion can be asserted. The relative degree of mean reversion across countries closely corresponds to often assumed degrees of economic integration vis-a-vis Germany as well as documented degrees of credibility of the exchange rate policies pursued. Convergence in fundamentals appears to be larger under the 'new' EMS than in the previous years but has again diminished after German unification and the subsequent widening of the ERM bands in 1993. Copyright 1999 by The editors of the Scandinavian Journal of Economics.