A New Solution to the Purchasing Power Parity Puzzles: Risk-Aversion, Exchange Rate Uncertainty and the Law of One Price
31 Pages Posted: 12 Feb 2009
Date Written: February 12, 2009
Market imperfections are the main explanation offered by the existing literature for violations of the Law of One Price and Purchasing Power Parity (PPP) among industrialized countries. We argue that even in perfectly frictionless markets risk aversion driven by exchange rate uncertainty causes a wedge between the domestic and foreign price of a totally homogeneous good. We test this hypothesis on a unique data set from a real-world market with minimum imperfections; and aggregate data for bilateral US dollar exchange rates in the G7 area. The empirical findings validate our hypothesis, thus providing a new, additional to market-imperfections, solution to the PPP puzzles.
Keywords: Law of one price, purchasing power parity, risk aversion, exchange rate uncertainty
JEL Classification: F31, F41
Suggested Citation: Suggested Citation