Non-Linear Dynamics in Deviations from the Law of One Price: A Broad-Based Empirical Study

41 Pages Posted: 21 Jun 2002

See all articles by Lucio Sarno

Lucio Sarno

City University London - Sir John Cass Business School; Centre for Economic Policy Research (CEPR)

Mark P. Taylor

Washington University in St. Louis - John M. Olin Business School; Centre for Economic Policy Research (CEPR)

Ibrahim Chowdhury

University of Oxford

Date Written: May 2002

Abstract

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.

Keywords: Law of one price, purchasing power parity, real exchange rate, threshold non-linearity, mean reversion

JEL Classification: F31

Suggested Citation

Sarno, Lucio and Taylor, Mark Peter and Chowdhury, Ibrahim, Non-Linear Dynamics in Deviations from the Law of One Price: A Broad-Based Empirical Study (May 2002). CEPR Discussion Paper No. 3377. Available at SSRN: https://ssrn.com/abstract=316859

Lucio Sarno (Contact Author)

City University London - Sir John Cass Business School ( email )

106 Bunhill Row
London, EC1Y 8TZ
United Kingdom

Centre for Economic Policy Research (CEPR)

London
United Kingdom

Mark Peter Taylor

Washington University in St. Louis - John M. Olin Business School ( email )

One Brookings Drive
Campus Box 1156
St. Louis, MO 63130-4899
United States

Centre for Economic Policy Research (CEPR)

London
United Kingdom

Ibrahim Chowdhury

University of Oxford ( email )

Oxford
United Kingdom
+44 1865 282 892 (Phone)

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