Deviations from purchasing power parity: causes and welfare costs

We explore deviations from short-run purchasing power parity (PPP) across European cities, attempting to move beyond a 'first-generation' of papers that document very large border effects. We document two very distinct types of border effects embedded in relative prices. The first is a 'real barriers effect', caused by various barriers to market integration. The second is a sticky-consumer-price cum volatile exchange-rate effect. Both are shown to be important empirically, the second type especially so. We argue that the two effects are very different from each other. For the first type of effect, it is clear that border effects imply deadweight welfare losses. We argue that while the second type of border effect could be eliminated with fixed exchange rates, welfare is not necessarily increased. (C) 2001 Elsevier Science B.V. All rights reserved.