FRBSF Economic Letter
99-35; November 19, 1999
 Economic
Letter Index
Are We Globalized Yet?
The buzzword in popular international economics in the 1990s is "globalization."
And there's no doubt that financial markets have become increasingly integrated
internationally. The Mexican crisis of 1994 and the Asian crisis of 1997-98
demonstrate the importance of global capital markets in nations' economies.
Goods and services markets also appear to have become more integrated
in the 1990s, as regional trade arrangements and international trade agreements
have reduced trade restrictions. But if goods and services markets were
truly integrated, then prices would tend to be the same from country to
country. And casual observation suggests that this is not the case at
all. For example, travel to Europe was cheap in the mid-1980s, and millions
of Americans flocked there for their first trips abroad. By 1990, the
situation appears to have been reversed: America had become the inexpensive
travel destination. Stories were told of Japanese tourists buying Japanese-made
electronic consumer products in the U.S. at much lower prices than they
would pay in Japan. Now, at the end of the 1990s, American prices are
no longer bargains, but good buys can be found in Canada.
This Economic Letter examines why goods prices are different
from country to country, with a special focus on the U.S. and Canada,
two of the most integrated economies in the world.
Integration of markets
and goods prices
One might expect goods prices to be equalized across countries if markets
were truly integrated. If prices were higher in one country, entrepreneurs
might find it profitable to export goods from cheaper countries to the
higher-price country and make a profit. Then, as the supply of goods increases
to the high-price country, prices there would fall into line with the
other countries.
Globalization has not meant that the prices consumers pay for goods and
services have equalized across the world. That should not be surprising
for a couple of reasons. First, many products simply are not traded internationally.
Globalization has not made it any easier for a Parisian to have a view
of Mt. Rainier from his salon, or for a Seattleite to take a stroll to
the Left Bank to enjoy a good tarte tatin. The "price" of a house with
a view of Mt. Rainier is very much higher for a Parisian than for a Seattleite.
Many services--of which housing services are but one example--are not
easily traded. To be sure, economic theory maintains that market forces
still would tend to narrow the gap in prices of services internationally
as markets become globalized. For example, international trade tends to
raise wages in low-wage countries. Since a large component of the cost
of services is wages, there ought to be some tendency toward equalization
of prices of services even if the services themselves are not internationally
traded.
But even easily tradable goods have different prices in different locations,
as our everyday experience reveals. A quart of milk is more expensive
at the corner convenience store than at the large discount grocery store.
Yet more expensive is the small downtown market. It is easy to understand
this price differential in economic terms. Rents for the space to market
milk and other costs for the retailer vary widely even within a single
urban area. Sometimes the consumer is willing to pay the higher price
at the neighborhood convenience store or the downtown market. The cost
in terms of the shopper's time and travel expenses is often too great
to justify a trip to the discount grocery.
But these explanations do not account for the large differences across
countries in consumer prices. The problem is illustrated in Figure
1. The thin line plots the real exchange rate between U.S. and Canadian
dollars. This provides a measure of the overall consumer price level in
the U.S. relative to Canada as measured in a common currency--in this
case, the U.S. dollar. When that line rises above 1.0 on the right-hand-side
vertical scale, overall consumer prices are higher in Canada. As the graph
shows, Canadians paid higher prices in the late 1980s and early 1990s.
During that period many shopping centers sprang up just south of the border
near large Canadian cities, allowing some Canadians to take advantage
of low U.S. prices. Then for most of the 1990s the situation reversed.
Canadian consumer prices dipped below U.S. prices in 1993 and have stayed
below ever since. In 1999, overall Canadian consumer prices are only about
75% of U.S. consumer prices.
Prices in the U.S. and Canada
It is surprising to see such large swings in relative prices between
the U.S. and Canada. Surely these are two of the most integrated economies
in the world. If the term "globalization" applies anywhere, it is to these
two economies. They have a free trade agreement. Travel between them is
virtually unrestricted. The people speak a common language, levels of
education are similar, and even geographically the countries are quite
alike. Why should there be such large swings in prices?
The relative price of consumer products in different countries is closely
tied to exchange rates--the price of one currency in terms of another.
As the U.S. dollar price of a Canadian dollar rises, Canadian goods become
more expensive compared to U.S. goods. It may seem obvious that this should
happen. The Canadian department store sets prices in Canadian dollars
and the U.S. department store sets prices in U.S. dollars. The exchange
rate fluctuates substantially from day to day and month to month, but
most prices in the department stores change infrequently. A numerical
example shows how a change in the exchange rate can affect the relative
price. Suppose a particular model of television sells for 800 Canadian
dollars in Vancouver, and 500 U.S. dollars in San Francisco. If the exchange
rate is 0.61 U.S. dollars per Canadian dollar, the U.S. dollar equivalent
price of the television sold in Vancouver is $488 (equal to 800 times
0.61). Televisions are cheaper in Vancouver. If the Canadian dollar rises
in value to 0.65 U.S. dollars, the U.S. dollar price of the television
sold in Vancouver is $520. Now, televisions are cheaper in San Francisco.
But it is not easy to explain why these price differences persist and,
in particular, why relative prices track exchange rates over fairly long
periods of time. Following up on the numerical example, it might be that
for many months or years, the U.S. dollar prices of televisions are lower
in Vancouver than in San Francisco. Why does the television manufacturer
allow such a price discrepancy to persist? What makes it profitable to
charge different prices in the two cities? Perhaps the prices differ for
the same reason that a quart of milk is cheaper at the large grocery store
than at the downtown market. Maybe rents and other costs are higher for
the department store in San Francisco than for its counterpart in Vancouver.
But the available evidence undercuts that explanation. When the exchange
rate makes a large swing, the price differences reverse. When the Canadian
dollar gains in value, U.S. dollar prices of goods sold in Canada rise
even though there is no change in costs for the department store. For
long periods of time the original situation is reversed and San Francisco
has the lower U.S. dollar prices. The puzzle, then, is that prices charged
in the department store adjust so slowly when the exchange rate changes--economists
refer to this phenomenon as low "pass through."
Returning to Figure 1, the
thick line graphs the nominal exchange rate, which is the U.S. dollar
cost of Canadian dollars (left-hand vertical scale). Note how closely
the real exchange rate, that is, the relative price of goods (thin line)
tracks the nominal exchange rate. Apparently the drop in Canadian prices
since the early 1990s is almost exclusively due to the depreciation of
the Canadian dollar. The amount that a producer can earn by selling a
product in Canada has dropped considerably relative to what that producer
can get in the U.S.
A two-sided puzzle
This is really a two-sided puzzle. One side of the puzzle is why firms
continue to market goods in Canada at such low prices. It appears that
profit margins for goods sold in Canada must be much lower than for goods
sold in the U.S. Economic theory tells us that under these conditions,
firms should begin moving out of Canadian markets and into U.S. markets.
Exports to Canada from the U.S. should fall, and exports from Canada to
the U.S. should increase. As the supply of consumer products begins to
dry up in Canada, their prices should rise. At the same time, prices in
the U.S. should fall as supply increases. Figure
1, however, shows that the fall in Canadian prices relative to the
U.S. was unabated for seven years--from mid-1991 to mid-1998. This may
indicate that markets for goods are not so highly integrated.
The other side of the puzzle is the exchange rate. Why has the Canadian
dollar depreciated so much since 1991? Foreign exchange markets buy and
sell money, and they operate like other asset markets. In the short run,
the price of foreign exchange is primarily determined by expectations.
If investors expect the Canadian dollar to depreciate, they will sell
Canadian dollars. And if many investors are selling Canadian dollars,
then, indeed, it will depreciate. Like any other asset, Canadian dollars
must ultimately have some fundamental value that anchors expectations.
Economists believe that prices of goods represent that anchor. In the
long run, the Canadian dollar will only depreciate against the U.S. dollar
if Canada's inflation rate is persistently higher than the U.S.'s.
The difference in inflation rates in Canada and in the U.S. cannot explain
the 25% depreciation of the Canadian dollar in the 1990s. Sometimes there
are "bubbles" in asset markets. A bubble occurs when expectations do not
have an anchor. Expectations are self-fulfilling. Perhaps the prolonged
rise of the U.S. dollar against the Canadian dollar in the 1990s, in defiance
of any trend in prices, is an example of a bubble--the Canadian dollar
depreciated simply because investors expected it to depreciate, but with
no economic fundamentals justifying those expectations. Some have claimed
there are other examples of bubbles in foreign exchange markets--the U.S.
dollar relative to the German mark in the first half of the 1980s, or
the Japanese yen relative to the U.S. dollar in early 1995 are other examples
of bubbles.
If the depreciation of the Canadian dollar were a bubble, it could explain
why producers have not abandoned Canadian markets. Bubbles eventually
burst, and when they do there can be huge swings in asset prices. The
Japanese yen depreciated over 80% in just over three years--from 80 yen
to a dollar in May 1995 to 145 yen to a dollar in August 1998. It is entirely
plausible that the Canadian dollar could appreciate 20% to 30% in a short
time, leading to a similar swing in profit margins on sales in Canada
relative to profit margins in the U.S. Those U.S. producers that have
made inroads into the Canadian market might not be willing to abandon
the market under current circumstances. They may have undertaken substantial
research and investment to be able to provide their goods to Canadian
markets. With the current weakness of the Canadian dollar, their profit
margins are squeezed. But they will not abandon the market if they believe
the foreign exchange market has a bubble that might burst dramatically.
It will be better to ride out the current situation and wait until Canadian
sales are again profitable than to abandon the market altogether. If they
stop selling in Canada they will have lost the market share that was costly
to obtain. When the Canadian dollar regains strength, it is better to
be in the market already than to undertake once again the expense of gaining
a toehold in the Canadian market.
Conclusion
The huge differences in consumer prices across countries are a challenge
for economic theory to explain. These differences persist despite increasing
integration of markets for goods around the world. Perhaps these differences
really come about not because goods markets are poorly integrated, but
because goods producers do not fully pass through the effects of exchange
rate changes or because foreign exchange rates are sometimes subject to
bubble behavior.
Charles Engel
Professor of Economics, University of Washington,
and Visiting Scholar, FRBSF
Reference
Engel, Charles, and John H. Rogers. 1996. "How Wide Is the Border?" American
Economic Review 86 (December) pp. 1,112-1,125.
Opinions expressed in this newsletter do not necessarily reflect
the views of the management of the Federal Reserve Bank of San Francisco
or of the Board of Governors of the Federal Reserve System. Editorial
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