The Limits of Arbitrage: Trading Frictions and Deviations from Purchasing Power Parity

The basic rationale for the doctrine of Purchasing Power Parity (PPP) is arbitrage in international markets for goods. This paper builds on the argument that frictions in international markets for goods limit the opportunity to exercise arbitrage, thereby creating a band of inaction around the PPP value of the real exchange rate. The existence of the band implies a discrete nonlinear real exchange rate adjustment process: Inside the band, where there are no arbitrage opportunities, the real exchange rate exhibits no central tendency; arbitrage activity translates into fast real exchange rate adjustment outside the band. Applying a threshold autoregression framework that explicitly captures the notion of the band of inaction to data from two sources and at different frequencies, I estimate the width of the band and the speed of adjustment to the edge of the band for a large set of bilateral real exchange rates. I find that the width of the band is in the range of 20 to 25 percent and that the half life of deviations from the edge of the band is at most two thirds of a year. I proceed to demonstrate that the width of the band is related to a variety of trading frictions including transport costs, tariff barriers and nominal exchange rate volatility.