A proposition on short-run departures from the law-of-one-price: Unanticipated inflation, relative-price dispersion, and commodity arbitrage

Abstract

This paper proposes an explanation of short-run departures from the law-of-one-price based on the characteristics of the inflationary process and changes in the distribution of relative prices. Unexpected inflation gives rise to volatility of relative prices. The more unexpected (and hence uneven) the rate of inflation, the greater the difficulty in discerning from a given structure of relative prices commodity-arbitrage opportunities which may be expected to persist and those transient opportunities which do not warrant a firm's incurring fixed costs of arbitrage. An illustration portrays a risk-averse firm confronting an international arbitrage opportunity.