Understanding European Real Exchange Rates

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Abstract
We study good-by-good deviations from the Law-of-One-Price for over 5,000 goods and services between European Union countries for the years 1975, 1980, 1985 and 1990. We find that between most countries there are roughly as many overpriced goods as there are underpriced goods. This feature is robust across years, in spite of relatively large movements in nominal exchange rates. Equally-weighted and CPI-weighted averages of good-by-good relative prices generate relatively accurate predictions of most nominal cross-rates, as purchasing power parity would suggest. Variation around the averages is large but is found to be related to economically meaningful characteristics of goods such as international tradeability, non-tradedness of factors of production and the competitive structure of the markets in which the goods are sold. Using data on product brands, we find that product heterogeneity is at least as important as geography in explaining relative price dispersion. Overall, our data provide strong evidence that international goods markets are segmented, but (i) the evidence relies on absolute deviations from the Law-of-One-Price, not deviations from PPP, (ii) some markets are much more segmented than others, with the disinctions being well predicted by economic theory.
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