Monetary union, price level convergence, and inflation: How close is Europe to the United States? John H. Rogers* July 2000 (Current Draft: January 11, 2003) Abstract: I document the pattern of price dispersion across European and U.S. cities from 1990 to 2001. I find a striking decline in dispersion for traded goods prices in Europe, most of which took place between 1991 and 1994. The level of traded goods price dispersion in the euro area is now quite close to that of the United States. I examine several possible explanations for the decline in Europe: harmonization of tax rates, convergence of incomes and labor costs, liberalization of trade and factor markets, and increased coherence of monetary policy. Surprisingly, there is only weak correlation between changes in the dispersion of traded goods prices and nominal exchange rates. I also investigate the determinants of national inflation rates in Europe. Although some is explained by price level convergence, conventional factors are more important. There is no evidence of a Balassa-Samuelson effect on inflation. Finally, after showing that prices in likely next-round entrants into the euro zone are well below prices in Western Europe, I discuss the potential inflationary consequences of accession into monetary union for Eastern Europe. JEL classification: E31, F36, F41 Keywords: economic integration, prices, exchange rates, euro * Senior economist, International Finance Division, Board of Governors of the Federal Reserve System, Washington, D.C. 20551. 202-452-2873,
[email protected]. I am grateful to seminar participants at Bocconi, Georgetown, Virginia, West Virginia, Federal Reserve System Committee on Macroeconomics meeting in Philadelphia, my colleagues at the Board of Governors, Paolo Pesenti and Jonathan Willis for comments on earlier versions of the paper, to Shing-Yi Wang for tireless research assistance and to David Bowman for putting up with endless conversations about the paper.