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

Inkoo Lee and Sang Soo Park

MPRA Paper from University Library of Munich, Germany

Abstract: This paper analyzes the role of goods market frictions in accounting for the large and volatile deviations from the Law of One Price in a framework of flexible prices. We draw a distinction between 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: 2015-09-01
New Economics Papers: this item is included in nep-int and nep-opm
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (1)

Downloads: (external link)
https://mpra.ub.uni-muenchen.de/66470/1/MPRA_paper_66470.pdf original version (application/pdf)

Related works:
Journal Article: 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:pra:mprapa:66470

Access Statistics for this paper

More papers in MPRA Paper from University Library of Munich, Germany Ludwigstraße 33, D-80539 Munich, Germany. Contact information at EDIRC.
Bibliographic data for series maintained by Joachim Winter ().