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

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  • Obstfeld, Maurice
  • Taylor, Alan M

Abstract

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.

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Paper provided by C.E.P.R. Discussion Papers in its series CEPR Discussion Papers with number 1672.

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Date of creation: Jul 1997
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Handle: RePEc:cpr:ceprdp:1672

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Keywords: Exchange Rate Volatility; Law of one price; Purchasing Power Parity; Real Exchange Rate; Transaction Costs; Transport Costs;

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  1. Maurice Obstfeld, 1999. "Open-Economy Macroeconomics, Developments in Theory and Policy," NBER Working Papers 6319, National Bureau of Economic Research, Inc.
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  18. Sercu, Piet & Uppal, Raman & Van Hulle, Cynthia, 1995. " The Exchange Rate in the Presence of Transaction Costs: Implications for Tests of Purchasing Power Parity," Journal of Finance, American Finance Association, vol. 50(4), pages 1309-19, September.
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