The Price Impact of Joining a Currency Union: Evidence from Latvia

Alberto Cavallo, Brent Neiman and Roberto Rigobon

IMF Economic Review, 2015, vol. 63, issue 2, 297 pages

Abstract: Does membership in a currency union matter for a country’s international relative prices? The answer to this question is critical for thinking about the implications of joining (or exiting) a common currency area. This paper is the first to use high-frequency good-level data to provide evidence that the answer is yes, at least for an important subset of consumption goods. It considers the case of Latvia, which recently dropped its pegged exchange rate and joined the euro zone. The paper analyzes the prices of thousands of differentiated goods sold by Zara, the world’s largest clothing retailer. Price dispersion between Latvia and euro zone countries collapsed swiftly following entry to the euro. The percentage of goods with nearly identical prices in Latvia and Germany increased from 6 to 89 percent. The median size of price differentials declined from 7 percent to zero. If a large number of firms also behave this way, these results suggest that membership in a currency union has significant implications for a country’s real exchange rate.

Date: 2015
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