Working Paper

Threshold adjustment in deviations from the law of one price

Abstract: Using self-exciting threshold autoregressive models, we explore the validity of the law of one price (LOOP) for sixteen sectors in nine European countries. We and strong evidence of nonlinear mean reversion in deviations from the LOOP and highlight the importance of modelling the real exchange rate in a nonlinear fashion in an attempt to measure speeds of real exchange rate adjustment. Using the US dollar as a reference currency, the half-lives of sectoral real exchange rates shocks, calculated by Monte Carlo integration, imply much faster adjustment than the consensus half-life estimates of three to five years. The results also imply that transaction costs vary significantly across sectors and countries.

Keywords: Prices; Foreign exchange rates;

Status: Published in Studies in Nonlinear Dynamics and Econometrics, September 2008, 12(3)

Bibliographic Information

Provider: Federal Reserve Bank of St. Louis

Part of Series: Working Papers

Publication Date: 2008

Number: 2008-027