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.
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Notes
A large theoretical and empirical literature characterizes the decision of importers and exporters to price using local currency pricing (LCP) or producer currency pricing (PCP). The primary repercussion of the currency unit decision, however, is to set pass-through to either zero (as with LCP) or one (as with PCP) during the interval when prices are sticky. The impact of the choice of currency unit only persists after price adjustment due to complementarities with other sticky prices, and this impact is typically muted. See, for instance, Friberg (1998), Bacchetta and Wincoop (2005), Devereux, Engel, and Storgaard (2004), Goldberg and Tille (2008), and Gopinath, Itskhoki, and Rigobon (2010).
As elaborated in Cavallo, Neiman, and Rigobon (2014), there is no law requiring companies to set the same retail price across the euro zone countries.
The short span of post-euro data, however, implies that we lack much power to assess this and other pricing moments. For example, we cannot yet conclude whether there have been changes in the size or frequency of price changes other than those immediately associated with Latvia’s adoption of the euro.
See also Gil-Pareja and Sosvilla-Rivero (2008 and 2012).
We do not claim, of course, that pricing dynamics following a country’s exit of a currency union will simply be the reverse of those following a country’s entry. Nonetheless, we demonstrate that price setting appears to be state-dependent at the time of a change in currency regime. As we elaborate below, this is a useful input into thinking about what would occur were a country to exit the euro.
See Bems and di Giovanni (2014) for a discussion of Latvia’s recession and a characterization of its external adjustment during this period.
From October 1, 2013 to June 30, 2014 there was a compulsory “dual price display” period, in which traditional offline stores had to display prices in both currencies, with prices converted at the official rate. Online stores have the option to display prices in both currencies using a currency conversion calculator that is easily accessible for consumers. This requirement does not apply to advertising materials. See Regulation No. 178 (2013) for additional details.
Clothing and footwear receive a 6 percent weight in Latvia’s CPI.
Purchases made on Zara’s web page may not be shipped to countries other than that hosting the web page. At time of check out, the “Country” field in the shipping information cannot be changed.
Further, to try to calibrate the importance of in-store sales, we asked sales clerks at two offline Zara stores near Boston about the percentage of items that were on sale. They responded “less than 10 percent.” We then counted ourselves and found sales on a subset of 6 racks out of a total of 104 racks, implying far fewer than 5 percent of the items were on sale.
The vast majority of Zara’s prices are an integer number of euros or end with 0.95 or 0.99, a pattern that can be seen in Table 1. Could these price points explain our results? Imagine that before Latvia joined the euro, Zara wished to price in Latvia at a level ending with a “95” or “99” that came closest to their median price in the euro zone of 39.95. They could have charged 27.95 lats—itself one of the most common price levels (in local currency) in the euro zone—and gotten well within 1 percent of the euro zone price. Were Zara instead to only price at levels ending as 5.95 or 9.99, for instance, the intervals would be larger and more able to explain, mechanically, our results. This would then simply raise the puzzle of why Zara would put so much emphasis on the psychology of the price level (or, perhaps for some readers, would put a quantitative value on the importance of that psychology). See Friberg and Matha (2004) for evidence on the importance of these psychological pricing points at the time of the euro’s creation.
This minor increase is likely a reflection of the differences in seasons. Our 2014 data only include the winter and early spring, whereas the 2012–13 period averages across all four seasons.
We exclude a small number of weekly observations where the number of collected prices drops below 1,000 and omit week 26 of 2013 for Germany, week 27 of 2013 for Latvia and France, and week 28 of 2013 for Italy, where the spikes in price levels suggest possible problems with the scraping algorithm (though none of our conclusions are affected if in fact those observations are correct).
The units on all prices changed during this week. The 10 percent of price levels that did not change refer to cases where the level in lats at the end of 2013 equaled the level in euros in early 2014, such as if a good’s price was 27.99 lats in the last week of December 2013 and was 27.99 euros in the first week of January 2014.
For technical reasons, our scraping algorithm excluded temporary sales in January 2013, but added them subsequently. As a result, there is no comparable spike in price reductions in January 2013 as in January 2014.
We believe this pattern to be accurate, but do not emphasize the fact that adjustment took 1–2 months because we cannot rule out that scraping errors resulted in the exclusion of some goods in January, making it appear as though their price changes occurred in February.
We do not put much emphasis on short-lived jumps up or down in the series, such as that in Germany in mid-2013, as scraping errors will occasionally produce weeks with a very small number of items.
See Cochrane (2012) for a discussion of this idea in the context of predictions of a Greek exit from the euro zone. In such a hypothetical, were prices to quickly adjust as in state-dependent models, any real exchange rate movement would be muted.
We have spoken to a number of current and former employees (and reached out to more) of several companies that exhibit this pricing behavior, including Zara, but so far have been unable to ascertain why this pattern emerges. One difficulty is that pricing strategies constitute highly sensitive information for the companies. Some companies have told us they choose “pricing regions” based on market similarities, and the euro clearly constitutes one such pricing region. It remains unclear, however, why the degree of “market” similarity would change so dramatically the day a country enters a currency union, or why euro zone countries as different as Germany and Greece would be considered by some companies to be more similar than Germany and Denmark, which is outside of the euro zone but whose kroner is pegged to the euro.
In this sense, our results call for further work on pricing at the intersection of industrial organization and macro, along the lines of Carlton (1989), Zbaracki, and others (2004), Neiman (2010 and 2011), Hellerstein and Villas-Boas (2010), and Hong and Li (2013).
If price comparisons are the key driver of our results, however, it would be surprising that companies make it so easy for consumers to identify a given identical product in multiple countries. See, for example, Carlton and Chevalier (2001), which evaluates the extent to which simple tactics are used in other industries to deal with channel conflict arising from online discount retailers.
We note that of the eight companies studied in Cavallo, Neiman, and Rigobon (2014), the difference in price dispersion between currency unions and pegs was weakest for Mango.
We collected these data after Latvia’s entry to the euro, so cannot comment on how these stores priced under the previous pegged regime.
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Additional information
Supplementary information accompanies this article on the IMF Economic Review website (www.palgrave-journals.com/imfer)
*Alberto Cavallo is the Cecil and Ida Green Associate Professor of Applied Economics and Brent Neiman is an Associate Professor of Economics and Robert King Steel Faculty Fellow at the Booth School of Business at the University of Chicago. Roberto Rigobon is the Society of Sloan Fellows Professor of Applied Economics, both at the Sloan School of Management at the Massachusetts Institute of Technology. The authors thank Rudolfs Bems, Dennis Carlton, and Raphael Schoenle for very helpful comments, suggestions, and assistance with data collection. Diego Aparicio provided outstanding research assistance.
