The origin of the law of one price deviations: Insights from the good-level real exchange rate volatility

Abstract

What is the origin of the law of one price deviation? To address this issue, this paper exploits the properties of good-level real exchange rate (RER) volatility; nominal (real) shocks predict the positive (negative) correlation between price stickiness and volatility. Using the US and 25 European countries, we estimate the contribution of each shock based on a two-country model in local currency pricing and the empirical analysis. The results indicate that the weighted average contribution of nominal shocks to the overall good-level RER volatility is 71%.