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ABSTRACTRecent literature has established a link between the persistence of real exchange rates and the degree of inertia in Taylor rule monetary policy reactions functions. This paper provides a different view on this link by investigating how the size of Taylor rule reaction coefficients impacts the adjustment dynamics of the real exchange rate. Within a stylized sticky‐price open‐economy macro model, it is demonstrated that a stronger interest rate reaction to inflation in the Taylor rule raises the convergence speed of the real exchange rate. Conversely, raising the coefficient on the output gap or attending to the exchange rate in an open‐economy version of the Taylor rule slows down real exchange rate adjustment. In all cases, more rapid convergence comes at the cost of stronger initial real exchange rate misalignments in the wake of monetary policy shocks.

This paper investigates whether Europe is converging towards becoming an optimum currency area. To this end, a structural vector autoregression with exclusively long‐run exclusion restrictions is employed on European bilateral real exchange rates, relative CPIs and real output to compare the incidence of the underlying shocks to aggregate supply, aggregate demand and the money market over time. Inferences on historical convergence are drawn for the EU15, the 11 countries originally participating in the European Monetary Union (EMU11) and the original members of the exchange rate mechanism of the EMS (EMS6). The results indicate significant convergence across the EU.