DP3377 Non-Linear Dynamics in Deviations from the Law of One Price: A Broad-Based Empirical Study

Author(s): Ibrahim Chowdhury, Lucio Sarno, Mark P Taylor
Publication Date: May 2002
Keyword(s): law of one price, mean reversion, purchasing power parity, real exchange rate, threshold non-linearity
JEL(s): F31
Programme Areas: International Macroeconomics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=3377

In this Paper we test empirically the validity of the law of one price using data for five major bilateral US dollar exchange rates and nine goods sectors during the recent floating exchange rate regime since the early 1970s. Using threshold autoregressive models, we find strong evidence of non-linear mean reversion in deviations from the law of one price with plausible convergence speeds. Consistent with theoretical arguments on international goods markets arbitrage under transactions costs and with an emerging strand of empirical literature, these results contribute towards forming a consensus view in favour of discrete regime switching in deviations from the law of one price and the presence of differing non-zero transactions costs across a broad range of goods and countries.