DP1672 Nonlinear Aspects of Goods-Market Arbitrage and Adjustment: Heckscher's Commodity Points Revisited

Author(s): Maurice Obstfeld, Alan M. Taylor
Publication Date: July 1997
Keyword(s): Exchange Rate Volatility, Law of one price, Purchasing Power Parity, Real Exchange Rate, Transaction Costs, Transport Costs
JEL(s): F31, F41
Programme Areas: International Macroeconomics
Link to this Page: www.cepr.org/active/publications/discussion_papers/dp.php?dpno=1672

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.