Price Convergence through a Financial Network: Does Financial Integration Impact Price Integration in Real Sectors?

Zhihao Xu, Tsinghua University

How does financial integration impact price integration in real sectors? Using newly hand-collected data from a domestic exchange market during the Chinese Civil War (1945-1949), I model the connection between these two integrations measured respectively by capital flow costs (or domestic exchange rates) and commodity relative prices across cities. I use battle shocks to a financial hub in the exchange network to identify the impact of exchange rates on price convergence between a city pair connected to the hub. I find that (1) city pairs with a direct domestic exchange link exhibited faster commodity price convergence than others; (2) battles around financial hubs tended to raise capital flow costs between a connected city pair, decelerating price convergence by 4% - 8%; (3) a weak form of purchasing power parity holds: a 1% depreciation in the domestic exchange rates was associated with a 0.2%-0.3% reduction in inflation rate differentials; and (4) a higher inflation rate did not impede or strengthen the price convergence channel via domestic exchanges. These results imply that China's financial development was more sophisticated than expected relative to its status as an agricultural economy in the early 20th century.

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 Presented in Session 263. Trade, Finance, Power and Market Structures