Working Paper: CEPR ID: DP1672
Authors: Maurice Obstfeld; Alan M. Taylor
Abstract: We propose that analysis of purchasing power parity (PPP) and the law of one price (LOOP) should explicitly take into account the possibility of ?commodity points? ? thresholds delineating a region of no central tendency among relative prices, possibly due to lack of perfect arbitrage in the presence of transaction costs and uncertainty. More than 80 years ago, Heckscher stressed the importance of such incomplete arbitrage in the empirical application of PPP. We devise an econometric method to identify commodity points. Price adjustment is treated as a non-linear process, and a threshold autoregression (TAR) offers a parsimonious specification within which both thresholds and adjustment speeds are estimated by maximum likelihood methods. Our model performs well using post-1980 data, and yields parameter estimates that appear quite reasonable. Adjustment outside the thresholds might imply half-lives of price deviations measured in months rather than years, and the thresholds correspond to popular rough estimates of the order of magnitude of actual transport costs. The estimated commodity points appear to be positively related to objective measures of market segmentation, notably nominal exchange rate volatility.
Keywords: Law of One Price; Purchasing Power Parity; Transaction Costs; Transport Costs; Real Exchange Rate; Exchange Rate Volatility; Trade Barriers
JEL Codes: F31; F41
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Higher transaction costs (D23) | Wider bands of inaction in price adjustments (L11) |
| Price deviations outside thresholds (D43) | Shorter half-lives of price deviations (G19) |
| Higher nominal exchange rate volatility (F31) | Impedes international arbitrage (F14) |