The Modern Theory of the LOP and PPP: Some Implications
What I call the modern theories of the law of one price and purchasing power parity extend those theories in two important ways: First by recognizing the nonlinearities caused by transaction costs and other impediments to trade and second by recognizing the importance of time in commodity arbitrage. This new approach, which has developed for the last two decades, raises questions about many widely accepted ideas. These ideas include the following: (1) The relevance of PPP. (2) Tests for cointegration and unit roots. (3) Relative versus absolute PPP. (4) Border effects. (5) Excessive volatility. (6) Large half lives for deviations from PPP. (7) The large increase in the volatility of exchange rates after the collapse of Bretton Woods.