This paper provides empirical evidence on the effectiveness of movements in nominal exchange rates in smooting cyclical imbalances between countries, as explained by the literature on optimal currency areas.

Inflation has fallen dramatically in countries like Spain and Italy over the last decade, but the rate of increase in "home good" prices remains stubbornly higher than the rate of increase in "traded good" prices. The paper begins by showing that this discrepancy can be explained (at least in...