The border effect in small open economies

This paper examines the importance of the national border in relative price variability in two neighboring, small open economies. Using monthly frequency price data of narrowly defined, homogenous consumer products, it finds that the time-series variation in within-country relative prices is about the same in the two countries. After controlling for distance, relative price variation is significantly higher across than within countries. The border is the dominant determinant of relative prices, even after accounting for nominal exchange rate variability and local culture as represented by language spoken. Our estimates of the border effect are largely immune to the bias identified in Gorodnichenko and Tesar [Gorodnichenko, Y., Tesar, L., 2006. Border effect or country effect? Seattle is 110 miles from Vancouver after all. Unpublished manuscript].