1 Limiting Currency Volatility to Stimulate Goods Market Integration: A Price Based Approach by David Parsley and Shang-Jin Wei Vanderbilt University Brookings Institution

2 Introduction zDoes exchange rate stabilization affect goods market integration? zWe distinguish two types of stabilization yInstrumental - reducing exchange rate volatility through intervention in the fx market yInstitutional - reducing volatility through an explicit currency board or common currency

3 Introduction zTwo strands of empirical research into goods market integration: ystudies examining actual flows of goods yprice-based studies (e.g., PPP, LOP) zWe adopt a price-based approach ya unique multi-country data set on prices of very disaggregated products (e.g., light bulbs & onions)

4 Studies of observed trade flows zMcCallum (95), Wei (96), Heliwell (98) yconclusion: observed volume of trade across national boundaries are much less than within countries zRose (2000), Frankel and Rose (2000), Rose and Engel (2000), Rose and van Wincoop (2001) yconclusion: common currencies increase bilateral trade by as much as 300%

5 Limitations of observed trade flows zTwo countries may have similar endowments and autarkic prices  low trade ztwo countries may trade extensively with a 3rd country but little w/each other zWei (1996) argues welfare implications from observed trade flows need auxiliary assumptions

6 Intuition zIf two countries produce similar (highly substitutable) output, increased trade may raise welfare only marginally zAlternatively, if two countries have distinct comparative advantages, a slight rise in trade may substantially raise welfare

7 Economist Intelligence Unit Price Data zLocal currency price comparisons for > 160 goods and services from up to 122 cities yWe select 95 goods and 83 cities

8 Sample of Economist Price Data

9 Cities Included

10 zLet be the U.S. dollar price of good k in city i at time t. For a given city pair (i,j) and a given good k at a time t, we define the common currency percentage price difference as: Our Approach

11 Our Approach zWe study all bilateral price comparisons the data allow. zThere are 3403 city pairs (=(83x82)/2) – each with 11 (annual) time periods. zThus, for each of the 95 prices the vector of price deviations will contain 37,433 (3403x11) observations without missing values.

12 Dispersion in Price Differences zWe focus on the cross sectional dispersion (across goods) of common currency price differentials for each city-pair and time period zAny particular realization of the common currency price differential, Q(ij,k,t) can be either positive or negative without triggering arbitrage as | Q(ij,k,t) | < the cost of arbitrage

13 Dispersion and Market Integration zThe existence of arbitrage costs implies that must fall within a range zAny reduction to barriers to trade (i.e., movements toward market integration) should reduce the no-arbitrage range. Therefore the strategy we adopt is to study a measure of the dispersion of Q(ij,k,t) through time

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17 Regression analysis zWe estimate the following baseline equation:

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19 Discussion zDispersion increases with distance zExchange rate variability increases dispersion yreducing it to zero from the sample average, reduces dispersion by.26% (=.067*.039*100) zParticipating in a Hard Peg yreduces dispersion by 4.4% - an order of magnitude bigger

20 Discussion (continued) zBeing a member of the CFA has no effect zBeing a member of the euro ~ to hard peg zBeing in a political union (US) has the largest institutional effect

21 Tariff Equivalents zEffect of the euro: ~ 4 percentage point reduction in tariffs  on the same order of magnitude as the elimination of tariffs under the common market program zEffect of reducing xr volatility to zero for any random pair of countries is only 0.3% zEffect of political & economic Union (U.S.) ~13 percentage point reduction in tariffs

22 Summary zInstitutional exchange rate stabilization has a much larger effect than instrumental stabilization zreducing xr vol < hard peg < full economic & political integration zThe effect is non-trivial. On the order of the common market effect zA non-credible peg (CFA) has no effect

23 Robustness & Extensions zAdditional explanatory variables zre-definitions of explanatory variables zdifferent measures of dependent variable zalternative econometric specifications

24 Conclusions zInstitutional exchange rate stabilization matters for goods market integration. zThe economic benefits of currency unions (Hard pegs) are an order of magnitude larger than simply reducing exchange rate vol to zero zOur results suggest that further economic and political integration can have an additional substantial impact on goods market integration