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Measuring Arbitrage Costs from Relative Prices: Implications for the PPP Puzzle

Author

Listed:
  • Huh , In

    (Korea Institute for International Economic Policy)

  • Lee , Inkoo

    (Soongsil University)

Abstract

This paper estimates the arbitrage costs from international relative prices, and studies the economic determinants of implied arbitrage costs. We find that the magnitude of arbitrage costs depends on the characteristics of both the type of good and set of locations under examination. More specifically, higher share of non-traded input and lower tradability of good lead to larger arbitrage cost, as does a lower proximity of geographic distance between locations. The role of location-specific characteristic in accounting for the arbitrage cost is more significant as we move beyond an economic geography, while good-specific characteristics matter relatively more if we move to the interior of this geography. We also show that arbitrage cost plays an important role in explaining the puzzling behavior of real exchange rate. We view our evidence as complementary to those that emphasize the role of nominal price rigidities.

Suggested Citation

  • Huh , In & Lee , Inkoo, 2011. "Measuring Arbitrage Costs from Relative Prices: Implications for the PPP Puzzle," Working Papers 11-11, Korea Institute for International Economic Policy.
    • Handle: RePEc:ris:kiepwp:2011_011
    DOI: 10.2139/ssrn.2319802
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    Keywords

    Arbitrage Costs; Threshold Autoregressive; Non-traded Input; Trade Share; Purchasing Power Parity;
    All these keywords.

    JEL classification:

    • C20 - Mathematical and Quantitative Methods - - Single Equation Models; Single Variables - - - General
    • F31 - International Economics - - International Finance - - - Foreign Exchange
    • F40 - International Economics - - Macroeconomic Aspects of International Trade and Finance - - - General

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