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Limiting Currency Volatility to Stimulate Goods Market Integration: A Price Based Approach by David Parsley and

Limiting Currency Volatility to Stimulate Goods Market Integration: A Price Based Approach by David Parsley and Shang-Jin Wei Vanderbilt University Brookings Institution. Introduction. Does exchange rate stabilization affect goods market integration?

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Limiting Currency Volatility to Stimulate Goods Market Integration: A Price Based Approach by David Parsley and

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  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 • Does exchange rate stabilization affect goods market integration? • We distinguish two types of stabilization • Instrumental - reducing exchange rate volatility through intervention in the fx market • Institutional - reducing volatility through an explicit currency board or common currency

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

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

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

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

  7. Economist Intelligence UnitPrice Data • Local currency price comparisons for > 160 goods and services from up to 122 cities • We select 95 goods and 83 cities

  8. Sample of Economist Price Data

  9. Cities Included

  10. Our Approach • Let 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:

  11. Our Approach • We study all bilateral price comparisons the data allow. • There are 3403 city pairs (=(83x82)/2) – each with 11 (annual) time periods. • Thus, 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 • We focus on the cross sectional dispersion (across goods) of common currency price differentials for each city-pair and time period • Any 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 • The existence of arbitrage costs implies that must fall within a range • Any 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

  14. Regression analysis • We estimate the following baseline equation:

  15. Discussion • Dispersion increases with distance • Exchange rate variability increases dispersion • reducing it to zero from the sample average, reduces dispersion by .26% (=.067*.039*100) • Participating in a Hard Peg • reduces dispersion by 4.4% - an order of magnitude bigger

  16. Discussion (continued) • Being a member of the CFA has no effect • Being a member of the euro ~ to hard peg • Being in a political union (US) has the largest institutional effect

  17. Tariff Equivalents • Effect 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 • Effect of reducing xr volatility to zero for any random pair of countries is only 0.3% • Effect of political & economic Union (U.S.) ~13 percentage point reduction in tariffs

  18. Summary • Institutional exchange rate stabilization has a much larger effect than instrumental stabilization • reducing xr vol < hard peg < full economic & political integration • The effect is non-trivial. On the order of the common market effect • A non-credible peg (CFA) has no effect

  19. Robustness & Extensions • Additional explanatory variables • re-definitions of explanatory variables • different measures of dependent variable • alternative econometric specifications

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

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