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How Big and Heterogeneous are the Effects of Currency Arrangements on Market Integration? A Price Based Approach

Vanderbilt University Financial Markets Research Center Working Paper No. 0113

48 Pages Posted: 8 Oct 2003  

David C. Parsley

Vanderbilt University - Finance

Shang-Jin Wei

Columbia Business School - Finance and Economics; National Bureau of Economic Research (NBER); Centre for Economic Policy Research (CEPR); International Monetary Fund (IMF); Tsinghua University - School of Economics & Management

Date Written: September 2003

Abstract

A rapidly expanding literature studies the effect of currency union and other exchange rate arrangements on goods market integration. All existing studies employ a methodology based on observed volumes of trade. However, from a theoretical point of view the connection between market integration and the volume of trade is loose. In this paper, we propose a different metric of market integration, based on the dispersion of prices of identical products in different countries. This metric is motivated by the theory of arbitrage in the presence of transaction costs. We apply the methodology to a unique 3-dimensional data set that includes prices of 95 very disaggregated goods (e.g., light bulbs and toothpaste with fluoride) in 83 cities around the world from 1990 to 2000. We find that a currency board or a currency union generally provides a stimulus to goods market integration that goes far beyond merely reducing exchange rate volatility to zero. However, there are important exceptions. Long-term currency unions exhibit greater integration than more recent currency boards. All existing arrangements can improve their integration further relative to a U.S. benchmark.

Keywords: pegs, currency board, dollarization, market integration

JEL Classification: F3, F2

Suggested Citation

Parsley, David C. and Wei, Shang-Jin, How Big and Heterogeneous are the Effects of Currency Arrangements on Market Integration? A Price Based Approach (September 2003). Vanderbilt University Financial Markets Research Center Working Paper No. 0113. Available at SSRN: https://ssrn.com/abstract=450680 or http://dx.doi.org/10.2139/ssrn.450680

David C. Parsley (Contact Author)

Vanderbilt University - Finance ( email )

401 21st Avenue South
Nashville, TN 37203
United States
615-322-0649 (Phone)
615-343-7177 (Fax)

Shang-Jin Wei

Columbia Business School - Finance and Economics ( email )

3022 Broadway
New York, NY 10027
United States

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

Centre for Economic Policy Research (CEPR)

77 Bastwick Street
London, EC1V 3PZ
United Kingdom

International Monetary Fund (IMF)

700 19th Street, N.W.
Washington, DC 20431
United States

Tsinghua University - School of Economics & Management

Beijing, 100084
China

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