TESTING INTERNATIONAL PRICE TRANSMISSION UNDER ...

Empirical Tests for Spatial Price Analysis
the domestic price, and p2t, the world price, we will have the following long-run
relation between them:
38
'
β p
⎡ 1
⎢
⎢
⎢⎣
p
[ β0
β1
β2
] p1t −1
= β0
+ β1
p1t
−1
+ β2
p2t−1
= z −1
t−
1 = t
2t−1
⎤
⎥
⎥
⎥⎦
where zt ≈ I(
0)
. Normalizing with respect to β1 and rearranging terms, we have
p
β
β
0 2
1t− 1 = − − p2t−1
+ zt−1
β1
β1
(3.32)
(3.33)
where β2 / β1 is the long-run price transmission elasticity: it indicates the
percentage change in the domestic price in response to a one-percent change in
the world price.
In international markets, price transmission elasticities show the extent to
which changes in world prices are transmitted back to country prices; Thompson
and Bohl (1999, p.2) argue that they can indeed be interpreted as a measure of the
degree of market insulation, or the extent to which border policies are transmitted
to domestic market. Price transmission is affected by trade liberalization and by
trade policies: in general, trade liberalization will contribute to greater price
transmission elasticities.
The point estimates of adjustment coefficients, which measure how much a
price responds to the disequilibrium from the previous period (in other words, the
larger the absolute value of the adjustment coefficient, the faster the convergence
toward the LOP), have important economic content (Thompson et al. 2002,
p.1044). The stationarity of price spreads requires α1 < 0 and α2 > 0. Moreover, the
weak exogeneity of one price with respect to the long run parameters requires its
adjustment coefficient to be zero 27 . Finally, the adjustment coefficient is a proxy
for the short run transmission elasticity.
The existence of a stable relations between two prices, i.e. bivariate
cointegration, has been deemed to be a necessary condition for integrated markets
since the seminal work of Ardeni (1989). Others claim that the strongest condition
that prices differences are stationary is needed, and thus impose instead of
estimating the cointegration vector (Baffes 1991). Cointegration tests are run pair
wise (Engle-Granger procedure) or with multivariate systems (Johansenn’s
27 In a VECM, weak exogeneity does not imply GC since GC involves statistical tests of significance also of
the lagged terms in addition to the parameters of the error correction terms.