Limiting Currency Volatility to Stimulate Goods Market Integration: A Price-Based Approach

Abstract

This paper empirically studies the effect of instrumental and institutionalstabilization of the exchange rate on the integration of goods markets.An instrumental stabilization of the exchange rate is accomplishedthrough intervention in the foreign exchange market, or by monetarypolicies. An institutional stabilization, is an adoption a currencyboard or a common currency. In contrast to the literature that employsdata on the volume of trade, an important novelty of this paper isthe use of a 3-dimensional panel of prices of 95 very disaggregatedgoods (e.g., light bulbs) in 83 cities from around the world from1990 to 2000. We find that goods market integration is increasingover time and is inversely related to distance, exchange rate variability,and tariff barriers. In addition, the impact of an institutionalstabilization of the exchange rate provides a stimulus to goods marketintegration that goes far beyond an instrumental stabilization. Amongthe institutional arrangements, long-term currency unions demonstrategreater integration than more recent currency boards. All of themcan improve their integration further relative to a U.S. benchmark.