Monetary integration and currency substitution in the EMS: The case for a European monetary aggregate

This paper examines the phenomenon of cross-currency substitution and the validity of monetary aggregation within the European Monetary System using non-parametric methods which exploit the relationship between intergroup substitution and separability. The separability property is tested using the methodology developed by Varian ('The Nonparametric Approach to Demand Analysis', Econometrica 50, 945-974, 1982; 'Nonparametric Tests of Consumer Behaviour', Review of Economic Studies 51, 99-110, 1983) and is violated in the case of most European countries, suggesting that the hypothesis of zero currency substitution which forms the basis of national monetary aggregation should be rejected. The results do however validate the use of monetary aggregates for the EMS as a whole, and I use a standard parametric demand for money approach to compare the performance of an EMS divisia index with that of simple sum aggregates during the 1980s and 1990s. (C) 1997 Elsevier Science B.V.