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Abstract
We propose that analysis of purchasing power parity (PPP) and the law of one price (LOOP)
should explicitly take into account the possibility of "commodity points" -- thresholds
delineating a region of no central tendency among relative prices, possibly due to lack of
perfect arbitrage in the presence of transaction costs and uncertainty. More than eighty years
ago, Heckscher stressed the importance of such incomplete arbitrage in the empirical
application of PPP. We devise an econometric method to identify commodity points. Price
adjustment is treated as a nonlinear process, and a threshold autoregression (TAR) offers a
parsimonious specification within which both thresholds and adjustment speeds are estimated
by maximum likelihood methods. Our model performs well using post-1980 data, and yields
parameter estimates that appear quite reasonable: adjustment outside the thresholds might
imply half-lives of price deviations measured in months rather than years, and the thresholds
correspond to popular rough estimates as to the order of magnitude of actual transport costs.
The estimated commodity points appear to be positively related to objective measures of
market segmentation, notably nominal exchange rate volatility.