What happens to prices when a country joins a currency union? And do prices behave differently in pegged exchange rate regimes compared to common currency areas? The answer to this question is a critical input to a country’s choice of currency regime.

History has, however, afforded few opportunities to study empirically such transitions. A number of papers examined this question in the context of the eurozone’s formation, with mixed results. For example, Goldberg and Verboven (2005) associated the euro with price convergence in a study of eurozone auto prices, whereas Engel and Rogers (2004) and Parsley and Wei (2008) studied different data sets and concluded the eurozone did not reduce price dispersion between its member economies. Latvia’s recent entry to the eurozone from a regime pegged to it offers a helpful case study to examine the impact of currency regimes on pricing behaviour and to try to answer these questions.

Evidence from Latvia

We study a cross-section of countries in and out of the eurozone (Cavallo, Neiman, and Rigobon 2014a). The prices of goods sold by multinational retailers, such as Apple and IKEA, vary widely across countries when comparing two economies with different currencies, including both floating and fixed exchange rate regimes. These same goods are dramatically more likely to sell for the identical price, however, when the countries share a common currency. In another paper (Cavallo, Neiman, and Rigobon 2014b), we exploit Latvia’s transition from a pegged regime (with a currency called the ‘lat’) to a Eurozone member in order to corroborate that the same pattern emerges over time within countries.

We scraped the online prices for thousands of goods sold by Zara, the world’s largest clothing retailer, before and after Latvia’s adoption of the euro on January 1st 2014. When Latvia was pegged to the euro, the typical good was priced at a level that differed from that in France, Germany, or Italy by 7%, after translating from lats into euros. After joining the euro, this 7% gap for the typical good dropped to zero.

Figure 1 plots for several countries the time series of the share of goods with the same price (defined as within 1%, after translating to common units) across the two countries. Prior to December of 2013, less than 10% of goods shared the same price with Latvia, whether comparing to eurozone countries like France, Germany, and Italy or to countries using other currencies – like the US.

In the weeks preceding Latvia’s entry to the eurozone, its prices for Zara goods began to converge to those in the other eurozone countries, as can be seen in the very sharp upticks of the first three lines. Interestingly, the transition started in November and December of 2013 and ended only a few months after the euro adoption, with the share of identical prices stabilising near 90%. This convergence was not a change in global pricing policies by Zara, as evidenced by the essentially flat line for the US in the fourth panel.

We hope future empirical and theoretical work builds on these findings and elaborates on the relationship between currency regimes and price-setting behaviour. Our results raise many questions. In which sectors did a similar transition occur and what are the drivers of this? Dvir and Strasser (2014), for example, study annual data on 150 car models and do not observe such a pattern for several other cases of small countries entering the eurozone. Would relative price movements have been different were the size of Latvia’s market larger relative to the rest of the common currency area? Would the reverse have occurred were a country to leave rather than join a currency union?

Authors: Alberto Cavallo is Cecil and Ida Green assistant professor of applied economics, MIT Sloan; Brent Neiman is associate professor of economics at University of Chicago Booth School of Business; Roberto Rigobon is Society of Sloan Fellows professor of applied economics at the Sloan School of Management, MIT.

Image: Women look at shoes in the newly-opened Riga Plaza shopping center in Riga April 8, 2009. REUTERS/Ints Kalnins