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.
| Original language | English |
|---|---|
| Pages (from-to) | 71-80 |
| Number of pages | 10 |
| Journal | Journal of Macroeconomics |
| Volume | 46 |
| DOIs | |
| Publication status | Published - 2015 |
Fingerprint
Keywords
- Distribution costs
- F31
- F37
- Law of one price
- Real exchange rate volatility
- Trade costs
ASJC Scopus subject areas
- Economics and Econometrics
Cite this
The law of one price revisited : How do goods market frictions generate large and volatile price deviations? / Lee, Inkoo; Park, Sang-Soo.
In: Journal of Macroeconomics, Vol. 46, 2015, p. 71-80.Research output: Contribution to journal › Article
}
TY - JOUR
T1 - The law of one price revisited
T2 - How do goods market frictions generate large and volatile price deviations?
AU - Lee, Inkoo
AU - Park, Sang-Soo
PY - 2015
Y1 - 2015
N2 - 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.
AB - 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.
KW - Distribution costs
KW - F31
KW - F37
KW - Law of one price
KW - Real exchange rate volatility
KW - Trade costs
UR - http://www.scopus.com/inward/record.url?scp=84954447373&partnerID=8YFLogxK
UR - http://www.scopus.com/inward/citedby.url?scp=84954447373&partnerID=8YFLogxK
U2 - 10.1016/j.jmacro.2015.08.001
DO - 10.1016/j.jmacro.2015.08.001
M3 - Article
AN - SCOPUS:84954447373
VL - 46
SP - 71
EP - 80
JO - Journal of Macroeconomics
JF - Journal of Macroeconomics
SN - 0164-0704
ER -