NONLINEAR ASPECTS OF GOODS-MARKET ARBITRAGE AND ADJUSTMENT - HECKSCHERS COMMODITY POINTS REVISITED

We propose that analysis of purchasing power parity (PPP) and the law of one price should explicitly take into account the possibility of '' commodity points''-thresholds delineating a region of no central tende ncy among relative prices, possibly due to lack of perfect arbitrage i n the presence of transaction costs and uncertainty. More than 80 year s ago, Heckscher stressed the importance of such incomplete arbitrage in the empirical application of PPP. We devise an econometric method t o identify commodity points. Price adjustment is treated as a nonlinea r process, and a threshold autoregression offers a parsimonious specif ication within which both thresholds and adjustment speeds are estimat ed by maximum likelihood methods. Our model performs well using post-1 980 data. and yields parameter estimates that appear quite reasonable: adjustment outside the thresholds might imply half-lives of price dev iations measured in months rather than years, and the thresholds corre spond to popular rough estimates as to the order of magnitude of actua l transport costs. The estimated commodity points appear to be positiv ely related to objective measures of market segmentation. notably nomi nal exchange rare volatility. (C) 1997 Academic Press.