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 eighty 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 nonlinear 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 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 as to 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 National Bureau of Economic Research, Inc in its series NBER Working Papers with number
6053.
Length: Date of creation: Jun 1997 Date of revision: Handle: RePEc:nbr:nberwo:6053
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Find related papers by JEL classification: F31 - International Economics - - International Finance - - - Foreign Exchange F41 - International Economics - - Macroeconomic Aspects of International Trade and Finance - - - Open Economy Macroeconomics
References listed on IDEAS Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
Froot, Kenneth A. & Kim, Michael & Rogoff, Kenneth, 1995.
"The Law of One Price Over 700 Years,"
Working Papers
95-13, C.V. Starr Center for Applied Economics, New York University.
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Balke, Nathan S & Fomby, Thomas B, 1997.
"Threshold Cointegration,"
International Economic Review,
Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 38(3), pages 627-45, August.
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repec:cup:cbooks:9780521326162 is not listed on IDEAS
Evans, G B A & Savin, N E, 1981.
"Testing for Unit Roots: 1,"
Econometrica,
Econometric Society, vol. 49(3), pages 753-79, May.
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