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A Reappraisal of the Border Effect on Relative Price Volatility

  • Yin-Wong Cheung
  • Kon Lai

Engel & Rogers (1996) find that crossing the US-Canada border can considerably raise relative price volatility and that exchange rate fluctuations explain about one-third of the volatility increase. Using a decomposition method, this study re-evaluates the border effect. It is shown that cross-country heterogeneity in price volatility can induce a bias in measuring the border effect unless proper adjustment is made to correct it. We further examine the implication of symmetric sampling for the border effect estimation under the decomposition approach. Two conditions governing the strength of the border effect are identified. In particular, the more dissimilar the price shocks are across countries, the greater the border effect will be. Decomposition estimates also suggest that exchange rate fluctuations actually account for a large majority of the border effect.

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Article provided by Taylor & Francis Journals in its journal International Economic Journal.

Volume (Year): 20 (2006)
Issue (Month): 4 ()
Pages: 495-513

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Handle: RePEc:taf:intecj:v:20:y:2006:i:4:p:495-513
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  1. Charles Engel & John H. Rogers, 1995. "How wide is the border?," International Finance Discussion Papers 498, Board of Governors of the Federal Reserve System (U.S.).
  2. Charles Engel & John H. Rogers, 1999. "Violating the Law of One Price: Should We Make a Federal Case Out of It?," NBER Working Papers 7242, National Bureau of Economic Research, Inc.
  3. Stephen G. Cecchetti & Nelson C. Mark & Robert J. Sonora, 2002. "Price Index Convergence Among United States Cities," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 43(4), pages 1081-1099, November.
  4. Charles Engel & John H. Rogers, 1998. "Relative Price Volatility: What Role Does the Border Play?," Working Papers 0061, University of Washington, Department of Economics.
  5. Janet Ceglowski, 2003. "The law of one price: intranational evidence for Canada," Canadian Journal of Economics, Canadian Economics Association, vol. 36(2), pages 373-400, May.
  6. Froot, Kenneth A & Klemperer, Paul D, 1989. "Exchange Rate Pass-Through When Market Share Matters," American Economic Review, American Economic Association, vol. 79(4), pages 637-54, September.
  7. Yin-wong Cheung & Eiji Fujii, 2005. "Cross-Country Relative Price Volatility: Effects of Market Structure," Working Papers 192005, Hong Kong Institute for Monetary Research.
  8. Engel, Charles, 1993. "Real exchange rates and relative prices : An empirical investigation," Journal of Monetary Economics, Elsevier, vol. 32(1), pages 35-50, August.
  9. Charles Engel & John H. Rogers, 2000. "Deviations from purchasing power parity: causes and welfare costs," International Finance Discussion Papers 666, Board of Governors of the Federal Reserve System (U.S.).
  10. Mario Crucini & Chris Telmer & Marios Zachariadis, . "Understanding European Real Exchange Rates," GSIA Working Papers 227, Carnegie Mellon University, Tepper School of Business.
  11. Engel, C., 1996. "Accounting for U.S. Real Exchange Rate Changes," Working Papers 96-02, University of Washington, Department of Economics.
  12. Depken, Craig II & Sonora, Robert J., 2002. "International price volatility: Evidence from U.S. and Mexican cities," The North American Journal of Economics and Finance, Elsevier, vol. 13(2), pages 179-193, August.
  13. Cheung, Yin-Wong & Chinn, Menzie & Fujii, Eiji, 2001. "Market Structure and the Persistence of Sectoral Real Exchange Rates," International Journal of Finance & Economics, John Wiley & Sons, Ltd., vol. 6(2), pages 95-114, April.
  14. Yuriy Gorodnichenko & Linda Tesar, 2005. "A Re-Examination of the Border Effect," Working Papers 546, Research Seminar in International Economics, University of Michigan.
  15. David C. Parsley & Shang-Jin Wei, 2000. "Explaining the Border Effect: The Role of Exchange Rate Variability, Shipping Costs, and Geography," NBER Working Papers 7836, National Bureau of Economic Research, Inc.
  16. Feenstra, Robert C. & Kendall, Jon D., 1997. "Pass-through of exchange rates and purchasing power parity," Journal of International Economics, Elsevier, vol. 43(1-2), pages 237-261, August.
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