Non-Linear Adjustment in Law of One Price Deviations and Physical Characteristics of Goods

Abstract

At a level of individual goods, heterogeneity of marginal transaction costs, proxied by price-to-weight ratios and stowage factors, explains a large part of the variation in thresholds of no-adjustment and conditional half-lives of law of one price deviations. Prices of heavier (more voluminous) goods deviate further before becoming mean-reverting. Moreover, after becoming mean-reverting, prices of heavier goods converge more slowly. Together with measures of pricing power, market size, distance and exchange rate volatility, these factors explain up to 43% of variation in no-adjustment threshold estimates across 52 goods in US-Canada post Bretton Woods monthly CPI data and are robust in a broader 5-country dataset. They open two avenues for the importance of marginal transaction costs in accounting for real exchange rate persistence: through (a) generating persistence in individual real exchange rate components, and (b) accentuating it by the process of aggregation of heterogeneous components ("aggregation bias" of .

General Equilibrium Model of Arbitrage Trade and Real Exchange Rate Persistence

“…(2003) find non-linear adjustment at sectoral level and show that the heterogeneity relates to distance and nominal exchange rate volatility. Berka (2002) shows that for disaggregated law of one price deviations between US and Canada, TAR(2,p,d) threshold estimates as well as conditional convergence speeds are significantly negatively correlated to price-to-weight and price-to-volume ratios for individual products. Price differences for heavier (or more bulky) goods sustain larger deviations before becoming mean-reverting.…”

“…In order to compute the share of the good that is used up in transportation, I use the the dataset of physical weights and average prices in 2001 used in Berka (2002). Approximately 24% of the goods in that dataset require refrigerating for transport.…”

“…It can be explained as a byproduct of heterogeneous trade costs. This idea is intuitive and empirically relevant (e.g., Berka 2002). Nominal rigidities may not be necessary in explaining persistence and volatility in price differences across countries.…”

“…The two general equilibrium models presented here show how physical characteristics of goods (or heterogeneous characteristics relevant for shipment in general) can explain persistence in deviations of good prices -and the real exchange rate -from parity. In an endowment world inhabited by identical consumers, three consumption goods are traded across borders for arbitrage purposes 3 . Goods only differ in their weight (a physical mass), which matters for shipment.…”