Europe Without Borders? The Effect of the EMU on Relative Prices

Has the formation of the European Monetary Union reduced the impact of national borders on cross-border market convergence? This paper extends Engel and Rogers (1996) well-known work on border effects to cities across Western Europe over the period 1995-2002 and finds two key results. First, cross-border relative prices tend to be more volatile than prices between locations not separated by a border. This result is robust to a variety of potential explanations for border effects, such as uneven sampling bias, idiosyncratic price shocks, and incomplete exchange rate-pass through. Turning our attention to cross-border price volatility before and after the formation of the EMU, the effects vary by country size. Within the EMU, cross-border price volatility has not changed between the "small" countries, but has fallen significantly between the large EMU countries. Between the EMU and the UK, cross-border volatility has increased between the UK and the small EMU countries, but there has been no significant change between the UK and the large EMU countries. These results are consistent with the fact that exchange rates are more likely to adjust to price differentials between small countries than between large countries.