October 30, 1998

We've said in the past that the organization of a nation's monetary system largely determines its inflation potential and its adjustment process to a new equilibrium following a financial shock. By recognizing a country's inflation potential and adjustment process, the global portfolio manager can develop insights that will enhance performance. This same framework will apply to the European Economic and Monetary Union after it begins in a few months. Our view is that, under a floating exchange-rate system where monetary shocks (i.e., inflation rate differentials) are a large component of nominal exchange-rate fluctuations, purchasing power parity is the most useful analysis framework. The road to, and the start of EMU is a monetary shock to the European economies-albeit a good one-but a shock nonetheless. As such, a purchasing power parity framework analysis is useful.

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