Three Essays on Convergence and Persistence of Prices in the European Union

This dissertation consists of three essays on the persistence and convergence of prices in the European Union. In the first essay I study price differentials in the Eurozone by comparing prices for specific goods between European cities, and estimate their persistence. The second essay tests the effect of the single market and single currency (euro) on price convergence in the European Union. The third essay tests the effect of trade on price convergence.

In my first essay, using the Economist Intelligence Unit data I find that the Southern countries of the Eurozone have consistently lower prices. While the Core states such as Germany and France are more expensive, price differentials within the Core are very low. Using panel data I estimate the persistence of deviations from the Law of One Price by employing linear and nonlinear panel unit root tests that account for contemporaneous as well as serial correlation. Based on the linear test, the estimated half-lives of the deviations from the Law of One Price are 13 months for traded goods and 15 months for non-traded goods. Price differentials for certain traded goods revert to parity at different speeds, for example prices for food adjusts much faster than for cars. Splitting the data series for individual goods into stationary and non-stationary components reduces the half-lives to 3 months for traded goods and 5 months for non-traded goods. The results of the nonlinear test suggest that the speed of reversion to parity is constant and independent of the size of the deviations, which implies prices based on good-specific data adjust in a linear rather than a nonlinear fashion.

The implementation of international treaties in the European Union was expected to promote integration of consumer markets. In my second essay, I analyze the convergence of prices for a range of traded goods. Large price differentials remain across Europe. Using high income non-euro European countries as a control group, I test the effect of the euro and the earlier implemented Single European Act on the convergence of prices in the European Union. Using a difference-in-difference estimation strategy, I find that the Single European Act, rather than the common currency, reduced price differentials and promoted price convergence.

Wide price differences still exist across the members of the European Union. While differentials among the ``old'' EU members have changed little over time, large price differentials between the Eastern and Central EU and the Eurozone have reduced significantly, with prices completely converging to the levels of the Southern EU.

In my third essay I test the effect of trade on price differentials. The fixed effects estimate shows strong correlation between price differentials and bilateral trade, a 1% increase in bilateral trade reduces price differences by 9%. This finding is completely driven by the Eastern and Central EU. Since the relationship between the price differentials and trade can go in either direction, an instrument is required to estimate a causal relationship. Instrumental-variables strategy shows that the effect of trade on price differentials for the Eastern and Central EU is even larger, at 13%, yet insignificant for the remaining EU members.