International financial integration and national price levels: The role of the exchange rate regime

Abstract

This paper proposes a new perspective on systematic deviations from purchasing power parity. Panel evidence for OECD countries shows that international financial integration increases the national price level under managed exchange rate regimes and lowers the price level under floating exchange rates. An open economy sticky-price model reproduces these findings by relating them to the possibility of insurance against consumption losses in internationally integrated financial markets. The utilization of insurance is reflected by relative price adjustments which manifest themselves in changes of the national price level. The direction of relative price adjustments, however, depends on the extent to which insurance is used under different exchange rate regimes: under a peg, financial integration raises the national price level; under a float, however, financial integration lowers the national price level.