Real Exchange Rate Variation and Failure of the Law of One Price: Does Geography Matter?

Using monthly and quarterly data from a sample of up to 741 real exchange rate series, we examine several factors to explain the failure of the Law of One Price and Purchasing Power Parity. The factors are often excluded or assumed away in traditional analysis of these theorems. The main findings include a positive significant relationship between real exchange rate variability and distance between countries, real output growth rate differentials and nominal exchange rate variability. A significant negative relationship exists with membership in trade groups such as the EEC and EFTA, and in countries that are islands.