Deviations from the LOP with labor and goods market frictions

This paper introduces search frictions in labor and goods markets to explore which condition leads to deviation from LOP, and how asymmetric shocks have an impact on deviation of LOP in an open economy. First, we show that the LOP gap only depends on the ratio of marginal utility of aggregate search across countries. Then, we express the LOP gap in terms of consumption gap across countries and show that asymmetric productivity shocks between countries entail deviations from LOP. This is because asymmetric productivity shocks affect markups via the matching probability, and in turn, induce firms to move across markets. Finally, we also examine responses of macroeconomic variables with respect to country-specific productivity and preference shocks.