The “Euro Illusion”: Illusion or Fact?

The changeover to the euro elicited an upsurge of research on the effects of the new currency on consumers’ conversion strategies, price estimates, price evaluations, choices, and purchases. This research includes longitudinal surveys, interviews, and controlled experiments, both natural and in the laboratory. The present article starts with an overview of this research after which it more specifically focuses on research showing an influence of the nominal value, as expressed in different currencies, on price evaluations and consumer choice. For most countries, the transition to the euro led to a lower nominal value currency. A bias known as the “euro illusion” has been documented such that the subjective value of money is influenced in the direction of the nominal value (i.e., in most countries prices and salaries seem smaller when expressed in euros than in the old domestic currency). Although the term was coined in connection with the euro changeover, the nominal representation of a currency has been shown to influence the subjective value of money in unfamiliar currencies other than the euro. Thus, tourists travelling abroad may frequently be subject to such an illusion. Different mechanisms have been proposed to account for the euro illusion. One is the numerosity heuristic and another the anchoring-and-adjustment heuristic in conjunction with biased conversion strategies. The size of the euro illusion is influenced by trade-offs between accuracy and effort. Consistent with this hypothesis, task importance, time constraints, familiarity with the conversion strategy, complexity of the conversion strategy, mood, and attitude towards the country or the currency all influence the size of the euro illusion.     

Does Euro or Dollar Pegging Impact the Real Exchange Rate? The Case of Oil and Commodity Currencies

The aim of this paper is to investigate the equilibrium exchange rates for commodity and oil currencies as well as the discrepancies of their observed exchange rates to these equilibriums. To this end, first, we estimate a long‐term relationship between the real effective exchange rate and economic fundamentals, including the commodity terms of trade. The estimation relies on panel cointegration techniques and covers annual data from 1980 to 2007. Our results show that real exchange rates co‐move with commodity prices in the long run and respond to oil price somewhat less than to commodity prices. Second, we assess the degree of misalignment of these currencies, as the gap between their observed exchange rate and the estimated equilibrium exchange rate. We show that these misalignments are not significantly related to the exchange rate regimes adopted by the countries, either pegged or floating. However, for pegged currencies, the size of misalignments significantly depends on the anchor currency, either the euro or the dollar. A comparison of misalignments of pegged commodity and oil currencies across different periods confirms these results: during periods of dollar (euro) overvaluation, currencies pegged to the dollar (euro) tend to be overvalued; the reverse being true when the dollar (euro) is undervalued. Consequently, pegged currencies are often driven away from their equilibria by wild fluctuations in the key currencies, on which they are anchored.     

Does Monetary Integration Reduce Exchange Rate Pass‐Through?

There are several theoretical arguments for why the adoption of a common currency (either a currency union or a currency board) may reduce the exchange rate pass‐through (ERPT) to domestic consumer prices. This paper examines a broad panel of 101 countries over the period 1976–2006, using two‐stage instrumental‐variable estimation techniques in order to resolve the potential endogeneity problem. The main result is that ERPT indeed tends to decline in countries participating in a common currency arrangement. In particular, there has been a strong reduction in pass‐through in the member countries of the European Monetary Union (EMU) since the launch of the euro. Currency boards do not appear to be different from currency unions – both reduce the pass‐through from depreciation to inflation. Furthermore, the negative impact of common currencies on ERPT is at work in both high‐income and low‐income countries. Finally, most of the reduction in pass‐through to consumer prices under common currency arrangements happens somewhere along the pricing chain between the border and the supermarket shelf.     

Yield curve risks in currency carry forwards

We provide empirical evidence that cross-country yield curve gaps (parallel gap, twist gap, and butterfly gap) are predictive to the expected currency carry premiums using currency forward contracts. We find that the expected currency gains are more notable as these yield curve risk factors at time t indicate short-term bond prices of investment currencies to go up (positive parallel movement, negative twist, and positive butterfly). We also find carry gains are more sensitively affected by cross-country monetary shocks than currency-country inflation pressures and business cycles. Our findings support that cross-country yield curve risk premiums still exist even after considering transaction costs.     

Discounting in International Markets and the Face Value Effect: A Double‐ Edged Sword?

Consumer response to price is often subjective and prone to systematic perceptual biases, such as the “face value” effect, whereby consumer perceptions of willingness to pay are systematically biased by the nominal value of a new currency. That is, prices presented in higher denomination currencies are perceived to be more expensive and prices presented in lower denomination currencies are perceived to be less expensive. The results from two separate experiments suggest that for high‐price products, when a substantial enough discount is invoked, the face value effect can reverse and becomes a double‐edged sword. While existing research implies that the face value effect becomes stronger for high‐price products, the findings from this research suggest this is the case only when the product is not being promoted. The findings also reveal that the face value effect is robust for low‐price products, even when there is a discount, providing further evidence of the effect in new contexts. Consistent with earlier research, this is because in real terms the discount for a low‐price product is not perceived as substantial enough. The experiments also suggest that for high‐price products, discounts framed as absolute amounts in higher denomination currencies are perceived to be more substantial than discounts framed as percentage amounts. These findings extend existing theory on the face value effect and have several important managerial implications for pricing management in international markets.     

Money: communicative functions of payment and price

ABSTRACT

Money is rich in semiotic potential and its capacity to express social identity and collectivity is well established. This essay explores a range of communicative functions of money, focusing in particular on the ways in which payments and prices may serve as cultural signals. It asks how the communicative significance of money might change as a result of the introduction of new types of currency, payment systems and pricing techniques, and suggests that such developments are likely to involve revisiting two key tensions: between state or corporate power on the one hand, and individual autonomy and privacy on the other; and between money’s power to generate collectivity and its power to divide and exclude.     

From dollarisation to euroisation

In the past the dollar has been so dominant as an international currency that the term ‘dollarisation’ has become a synonym for currency substitution, i.e. the voluntary use of a foreign currency instead of the respective country's own legal tender. This article addresses the question as to whether the euro may be expected to partly replace the US currency in this function, focusing on the former's use as a substitution currency in countries on the periphery of the euro zone. Some policy conclusions are drawn for both the ‘euroised’ economies and Euroland.     

The Euro Changeover and Numerical Intuition for Prices in the Old and New Currencies

This study examines how numerical intuition for prices in euros and in the Portuguese currency escudos developed in Portugal after the euro changeover. Estimates of prices of 40 different products were collected in the two currencies and at four different times from November 2001 to April 2004. The results regarding price estimates in euros were more in accordance with a relearning hypothesis considering that price estimates become progressively more accurate by a process that is related to purchase frequency. It was also suggested that this is a very slow process and that prices in the former currency are not simply forgotten. On the contrary, the escudos remained a general benchmark for an extended period. The results regarding estimated price intuition and use of intuition in estimating prices are also consistent with a slow adaptation process. Implications for future euro changeovers are discussed.     

Cross Hedging with Currency Forward Contracts

This study examines the behavior of a competitive exporting firm that exports to a foreign country and faces multiple sources of exchange rate uncertainty. Although there are no hedging instruments between the home and foreign currencies, there is a third country that has well‐developed currency forward markets to which the firm has access. The firm's optimal cross‐hedging decision is shown to depend both on the degree of incompleteness of the currency forward markets in the third country, and on the correlation structure of the random spot exchange rates. Furthermore, the firm is shown to be more eager to produce and expand its exports to the foreign country when the missing currency forward contracts between the home and foreign currencies can be synthesized by the existing currency forward contracts. In this case of perfect cross hedging, the separation theorem holds but the full‐hedging theorem may or may not hold. © 2012 Wiley Periodicals, Inc. Jrl Fut Mark     

Information content of cross‐sectional option prices: A comparison of alternative currency option pricing models on the Japanese yen

This article implements a currency option pricing model for the general case of stochastic volatility, stochastic interest rates, and jumps in an attempt to reconcile levels of risk‐neutral skewness and kurtosis with observed option prices on the Japanese yen and to analyze the information content of the cross section of option prices by investigating the hedging and pricing performance of various currency option pricing models. The study makes use of both a method of moments and a more traditional generalized‐least‐squares (GLS) estimation technique, taking advantage of the fact that methods of moments do not specifically require the use of cross‐sectional option prices, whereas GLS does. Results centered around the Asia economic crisis of 1997 and 1998 indicate that the cross section of option prices surprisingly does not appear to contain superior information as the two estimation techniques yield relatively similar results once idiosyncratic differences between them are acknowledged. Extensions of the G. Bakshi, C. Cao, and Z. Chen (1997) results to currencies are also provided. © 2006Wiley Periodicals, Inc. Jrl Fut Mark 26:33–59, 2006     

Export Performance,Invoice Currency and Heterogeneous Exchange Rate Pass‐through

Using comprehensive, shipment‐level merchandise trade data for a small, open economy, we examine heterogeneity in exporters' exchange rate pass‐through (ERPT) behaviour. We draw together two recent studies of ERPT, linking invoice currency decisions and firm performance to heterogeneity in ERPT. Like these studies, we find that the short‐run reaction of export unit values to exchange rate fluctuations is significantly related to both invoice currency choice and exporter characteristics when these are analysed separately. However, we then show that when the two factors are jointly accounted for, the role of exporter characteristics largely disappears. That is, some firm types are more inclined to invoice in the producer currency, while others use either the local or a vehicle currency. In the short run, this translates into differences in exchange rate pass‐through because of price rigidity in the invoice currency. Firm characteristics do not have an independent impact on pass‐through beyond their effect on currency composition. Differences across invoice currencies diminish over time, but do not disappear, as prices adjust to reflect bilateral exchange rate movements.     

An information approach to international currencies

Models of currency competition focus on the 5% of trading attributable to balance-of-payments flows. We introduce an information approach that focuses on the other 95%. Important departures from traditional models arise when transactions convey information. First, prices reveal different information depending on whether trades are direct or though vehicle currencies. Second, missing markets arise due to insufficiently symmetric information, rather than insufficient transactions scale. Third, the indeterminacy of equilibrium that arises in traditional models is resolved: currency trade patterns no longer concentrate arbitrarily on market size. Empirically, we provide a first analysis of transactions across a full market triangle: the euro, yen and US dollar. The estimated transaction effects on prices support the information approach.     

The currency denomination of exports — A questionnaire study

We report survey results on the currency choice of a random sample of Swedish exporters. We find that for an overwhelming share of exports, the price, invoice and settlement currency is the same. The currency of the customer is the most used, with Swedish kronor and vehicle currencies accounting for approximately equal shares. Currency choice is similar for intra-firm and between-firm trade. We also find that negotiations are important for both the price and for the currency choice. A minority of firms use posted prices for their main exports — the median price adjustment for those firms is once per year.     

An analysis of forward exchange rate biasedness across developed and developing country currencies: Do observed patterns persist out of sample?

Forward exchange rate unbiasedness hypothesis (FRUH) has been a widely researched subject for decades. Recently, the sample populations of these studies have expanded to include developing country currencies. The majority of these findings have been that forward rate biasedness is more pronounced for developed country currencies than it is for developing country currencies. One such paper (Frankel and Poonawala, 2010) has further suggested that this phenomenon may contradict Risk Premium Theory since developing country currencies are relatively more volatile. Our analysis first replicates the results of Frankel and Poonawala and then extends the study out of sample using an updated composition of currency classifications. The results of this extended period of analysis show that forward rate biasedness is less pronounced for developed country currencies than for developing country currencies and consequently does not establish grounds to challenge Risk Premium Theory. Furthermore, our results are consistent with another branch of literature which suggests that conflicting FRUH test results may be particular to the time period examined. It is therefore possible to speculate that period-specific factors were responsible for the results found in previous research.     

Exchange market pressure,commodity prices,and contagion in Latin America

Over the past two decades, Latin American currencies have faced not only pressure to devalue but also periods of uncomfortable appreciation. Domestic macroeconomic factors, as well as global events and contagion, might bear part of the responsibility. This study constructs a monthly index of exchange market pressure (EMP) for four Latin American countries before using vector autoregressive methods to test the influence of commodity prices, macroeconomic variables, and external factors on each country's index. While inflation is an important determinant of EMP, we conclude that Chile and Peru are more likely than Mexico and Brazil to face pressure when commodity prices fall. This supports the idea that these two countries have “commodity currencies” and that their exchange markets are most vulnerable to international contagion.     

Determinants shaping the international currency system: Where do currencies stand relative to their equilibria?

Using a sample of 27 currencies, we empirically test the role of a large set of determinants potentially underlying currencies' share in the international currency system, providing, to the best of our knowledge, the most comprehensive study of this kind so far. We propose a new global indicator that quantifies the international use of currencies on the basis of three dimensions—medium of exchange, unit of account and store of value. From a range of indicators including openness, financial development and institutional development indicators, we uncover several variables that are significant in explaining the international status of currencies, hence contributing to understanding the role of the determinants shaping the international currency system. We also investigate the long-run equilibrium values for currency shares, allowing us to score currencies on the basis of the potential stemming from the determinants. We contribute to the debate on international currencies' prospects, not only by looking at much discussed currencies such as the US dollar, the euro and the Chinese renminbi, but also by uncovering potential of emerging currencies. This knowledge is of the utmost importance for the debate on the reform of the international monetary system—from the point of view of academics, policymakers and market practitioners.     

Price competition with repeat, loyal buyers

Extant theoretical models suggest that greater consumer loyalty increases a firm’s market power and leads to higher prices and fewer price promotions (Klemperer, Quarterly Journal of Economics 102(2):375–394, 1987a, Economic Journal 97(0):99–177, 1987b, Review of Economic Studies 62(4):515–539, 1995; Padilla, Journal of Economic Theory 67(2):520–530, 1995). However, in some markets large, national brands that are able to generate more consumer loyalty than their rivals offer lower prices and promote more frequently. In this paper, we develop a two-period game-theoretic, asymmetric duopoly model in which firms differ in their ability to retain repeat, loyal buyers. In this market, we demonstrate that it is optimal for a firm that generates more loyalty to offer a lower average price and promote more frequently than a weaker competitor. Numerical analysis of a more general infinite period version of this asymmetric model leads to three additional results. First, we show that there is an inverted-U relationship between a weak firm’s ability to attract repeat, loyal consumers and strong firm profits. Second, we show that the relative ability of firms to attract repeat buyers affects whether serial and contemporaneous price correlations are positive or negative. Finally, we highlight the effect of dynamics on firms’ expected prices and profits.

The impact of sovereign wealth funds on global financial markets

If sovereign wealth funds act similarly to private investors and thus allocate foreign assets according to market capitalisation rather than liquidity considerations, official portfolios reduce their “bias” towards the major reserve currencies — the US dollar and the euro. As a result, more capital flows “downhill“ from rich to less wealthy economies. In this scenario, the euro area and the United States would be subject to net capital outflows while Japan and the emerging markets would attract net capital inflows. The potential implications of a rebalancing of international capital flows for stock prices, interest rates and exchange rates remain uncertain, however. The authors wish to thank Marcel Fratzscher for excellents comments. The views expressed in this paper are those of the authors and do not necessarily reflect those of the European Central Bank.     

Usage-Based versus Measure-Based Unit Pricing: Is there a Better Index of Value?

In many product categories, unit prices facilitate price comparisons across brands and package sizes; this enables consumers to identify those products that provide the greatest value. However in other product categories, unit prices may be confusing. This is because there are two types of unit pricing, measure-based and usage-based. Measure-based unit prices are what the name implies; price is expressed in cents or dollars per unit of measure (e.g., ounce). Usage-based unit prices, on the other hand, are expressed in terms of cents or dollars per use (e.g., wash load or serving). The results of this study show that in two different product categories (i.e., laundry detergent and dry breakfast cereal), measure-based unit prices reduced consumers’ ability to identify higher value products, but when a usage-based unit price was provided, their ability to identify product value was increased. When provided with both a measure-based and a usage-based unit price, respondents did not perform as well as when they were provided only a usage-based unit price, additional evidence that the measure-based unit price hindered consumers’ comparisons. Finally, the presence of two potential moderators, education about the meaning of the two measures and having to rank order the options in the choice set in terms of value before choosing, did not eliminate these effects.     

The Link Between Gasoline Prices and Vehicle Sales

This paper examines the link between fuel prices and sales of cars and trucks. U.S. automakers have long denied that such a link exists. One source of this false belief is an obsession with the crude count of units sold, equating Hummers with Minis. Another source is the conventional “wisdom” that Americans are unwilling to pay for fuel economy. The paper presents theoretical reasons and market evidence that refute Detroit’s conventional wisdom. American manufacturers’ reaction to rising fuel prices over the last few years revealed the shortcomings of the U.S. automakers’ recent product and powertrain strategies. The effect of rising fuel prices has, in effect, been offset by reducing prices of vehicles in inverse proportion to fuel economy. Thus, unit sales of large SUVs could be maintained, but their revenue (and profit) fell because vehicle prices were cut, directly or indirectly. The paper concludes with a few practical guidelines that business economists should use to prevent their companies from experiencing the recent massive losses experienced by the U.S. automobile industry. JEL Classification D120