Persistent Gaps Between Purchasing Power Parities and Exchange Rates Under the Law of One Price : a Puzzle (Partly) Explained?
Simple general equilibrium (exchange) models of intra-EU trade generate equalized relative prices of consumer tradables. Simultaneously, more dispersed domestic relative prices of consumer non- -tradables are generated. Consequently, the purchasing power parity/exchange rate ratios may move further away from unity. The PPP/ER discrepancies may widen even when there are no impediments to free trade. While the models force the relative prices of tradables into uniformity, in reality these prices are persistently dispersed across countries. This does not vitiate the law of one price though. The retail prices of tradables depend also on prices of the local (non-tradable) inputs (e.g. distribution services). Prices of tradables net of costs of services (unobservable) may tend to obey the law of one price. The observed (retail) prices of tradables may not show this tendency even under free and competitive foreign trade because such a trade can widen the gaps between prices of non-tradables internationally. (original abstract)
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