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 five-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 aggregation of heterogeneous components (“aggregation bias” of Imbs et al., 2005a).