Testing the law of one price under the fixed and flexible exchange rate systems

Abstract

This paper examines if the law of one price holds under different exchange rate regimes and if a simultaneous relationship exists among prices of different countries. The findings show that prices in industrial countries are related, as suggested by the monetary approach. Confirming the law of one price, our results show relative price movements play a negligible role in removing a disequilibrium in the balance of payments. These findings provide supportive evidence for the purchasing power parity (PPP) doctrine under the floating exchange rate system but not under the fixed exchange rate system.