Threshold Adjustment of 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 find 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 rate 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.