The law of one price revisited: How do goods market frictions generate large and volatile price deviations?

Inkoo Lee and Sang Soo Park

Journal of Macroeconomics, 2015, vol. 46, issue C, 71-80

Abstract: This paper analyzes the role of goods market frictions in accounting for the large and volatile deviations from the Law of One Price (LOP) in a framework of flexible prices. We draw a distinction between the goods market frictions that are required to consume tradable goods (e.g., distribution costs) and those that are necessary for international transactions (e.g., trade costs). We find that trade costs generate LOP deviations by introducing a no-arbitrage band, while distribution costs cause the price to deviate from the LOP by affecting the probability that trade will occur, given the band. We then conduct a Monte Carlo simulation to show that real exchange rate volatility is positively associated with trade costs, but negatively related to distribution costs. This effect depends on the interplay of trade costs and distribution costs, as they work in opposite directions when creating arbitrage opportunities.

Keywords: Distribution costs; Trade costs; Law of one price; Real exchange rate volatility (search for similar items in EconPapers)
JEL-codes: F31 F37 (search for similar items in EconPapers)
Date: 2015
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (1)

Downloads: (external link)
http://www.sciencedirect.com/science/article/pii/S0164070415000981
Full text for ScienceDirect subscribers only

Related works:
Working Paper: The law of one price revisited: How do goods market frictions generate large and volatile price deviations? (2015)
This item may be available elsewhere in EconPapers: Search for items with the same title.

Export reference: BibTeX RIS (EndNote, ProCite, RefMan) HTML/Text

Persistent link: https://EconPapers.repec.org/RePEc:eee:jmacro:v:46:y:2015:i:c:p:71-80

DOI: 10.1016/j.jmacro.2015.08.001

Access Statistics for this article

Journal of Macroeconomics is currently edited by Douglas McMillin and Theodore Palivos

More articles in Journal of Macroeconomics from Elsevier
Bibliographic data for series maintained by Catherine Liu ().