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 , purchasing power parity , real exchange rate , threshold non-linearity , mean reversion

JEL(s): F31

Programme Areas: International Macroeconomics

Link to this Page: www.cepr.org/pubs/dps/DP3377.asp

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.