What can we learn from deviations from the law of one price?
We use cross sectional data on local currency prices of over 1800 goods across 13 European countries to examine deviations from the law of one price. We find that an average (across goods for a particular country) of ratios of foreign to domestic prices provides a surprisingly accurate prediction of the nominal exchange rate for most cross--rates. Variation around this mean is large and is related to measures of tradeability, purchase size and geographical distance. Using data on product brands, we find that product heterogeneity is at least as important as geography in explaining relative price dispersion.
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