Price-Level Convergence: New Evidence from U.S. Cities
One sentence summary: Half life of price-level convergence is about 5 months across U.S. cities.
The corresponding paper by Ege Yazgan and Hakan Yilmazkuday has been published at Economics Letters.
The working paper version is available here.
Abstract
This paper tests the bilateral price-level convergence among 52 U.S. cities at the good level by using a new econometric approach. The estimated median half lives are far below the half lives found in the corresponding studies for the U.S.
Non-technical Summary
Purchasing power parity (PPP) and law of one price (LOP) have been subject to countless empirical investigations as they constitute central roles in models of macro economy. The bulk of this empirical research consists of testing (aggregate) price-level convergence across countries; i.e., testing the stationarity of aggregate real exchange rates. After decades of scrutiny, the consensus is that aggregate price levels expressed in common currency are convergent, but convergence rates are very slow. Real exchange rates are stationary but very persistent with estimated half-lives in the range of 3-5 years. This slow convergence is hard to rationalize on the basis of monetary factors and hence referred to as PPP puzzle.
Some researchers have taken an alternative route by considering price-level convergence across regions that share a common currency. This approach provides a more controlled environment, as problems due to fluctuations in exchange rate or factor market rigidities are eliminated. In these studies of price-level convergence across regions, the existence of unit root in the regional price relatives is jointly tested by conducting panel unit root tests, and half lives are calculated based on the estimates of panel unit root regressions. The main problem with these studies is that they use an arbitrary benchmark for constructing relative prices. The usual practice is to use either an arbitrarily chosen region or an aggregate measure (i.e. the average of all regions) as the benchmark.
Some researchers have taken an alternative route by considering price-level convergence across regions that share a common currency. This approach provides a more controlled environment, as problems due to fluctuations in exchange rate or factor market rigidities are eliminated. In these studies of price-level convergence across regions, the existence of unit root in the regional price relatives is jointly tested by conducting panel unit root tests, and half lives are calculated based on the estimates of panel unit root regressions. The main problem with these studies is that they use an arbitrary benchmark for constructing relative prices. The usual practice is to use either an arbitrarily chosen region or an aggregate measure (i.e. the average of all regions) as the benchmark.
To overcome the arbitrary benchmark problem, this paper uses a different approach which allows heterogeneity across city pairs and is valid even in the presence of cross sectional dependence. The data set includes 48 final goods and service prices obtained for 52 U.S. cities from 28 U.S. states. The data are provided by American Chamber of Commerce Researchers Associations (ACCRA) on a quarterly basis and cover the period 1990q1 through 2007q4 (totally 72 quarters).
A median (AIC) estimate of half life for all type of goods is 1.64 quarters, which is a significantly smaller figure compared to the existing literature. Tradable goods exhibit even quicker convergence rates nearly as below as 1.37 quarters for perishables. The half-life estimates of non-tradable goods indicate slower convergence with 2.75 quarters; even this number constitutes a significantly smaller estimate than the previous ones.