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

Inkoo Lee, Sang-Soo Park

Research output: Contribution to journalArticle

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 languageEnglish
Pages (from-to)71-80
Number of pages10
JournalJournal of Macroeconomics
Volume46
DOIs
Publication statusPublished - 2015

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Keywords

  • Distribution costs
  • F31
  • F37
  • Law of one price
  • Real exchange rate volatility
  • Trade costs

ASJC Scopus subject areas

  • Economics and Econometrics

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