Nonlinear Adjustment in Law of One Price Deviations and Physical Characteristics of Goods

At a level of individual goods, heterogeneity of marginal transaction costs, proxied by price‐to‐weight ratios and stowage factors, explains a large part of the variation in thresholds of no‐adjustment and conditional half‐lives of law of one price deviations. Prices of heavier (more voluminous) goods deviate further before becoming mean‐reverting. Moreover, after becoming mean‐reverting, prices of heavier goods converge more slowly. Together with measures of pricing power, market size, distance, and exchange rate volatility, these factors explain up to 43% of variation in no‐adjustment threshold estimates across 52 goods in US–Canada post‐Bretton Woods monthly CPI data and are robust in a broader five‐country dataset. They open two avenues for the importance of marginal transaction costs in accounting for real exchange rate persistence: through (a) generating persistence in individual real exchange rate components, and (b) accentuating it by the aggregation of heterogeneous components (“aggregation bias” of Imbs et al., 2005a).