Two seemingly unconnected empirical results suggest an intriguing mechanism. First, economic integration helps harmonize prices internationally, with trade being the primary channel (Rogoff 1996, Goldberg and Knetter 1997). Second, monetary union may greatly increase the amount of trade among members (Rose 2001). Putting these together, we see that formation of a monetary union may induce changes that help harmonise inflation rates. The effect might be large if the elimination of exchange rate volatility simultaneously leads to a large increase in intra-union trade and a big increase in the speed at which price shocks are transmitted across members' goods markets. The problem is that standard estimates of price transmission speed suggest that trade's price-homogenising effect operates too slowly to matter much. Some new empirical evidence, however, suggests that a reduction in exchange rate variability reduces the variability of international price differences. Moreover, the effect seems to be highly nonlinear, and monetary union seems to have an effect even controlling for exchange rate volatility. This paper is a first attempt to piece together part of this mechanism, namely the impact of monetary union (and exchange rate volatility more generally) on the international transmission of price shocks via the imported/exported inflation channel. In doing this we generate specific testable hypotheses and confront these with a number of data sets on European trade prices.
