Academic journal article East Asian Economic Review

Sectoral Price Divergence between Korea and Japan *

Academic journal article East Asian Economic Review

Sectoral Price Divergence between Korea and Japan *

Article excerpt

(ProQuest: ... denotes formulae omitted.)

I.INTRODUCTION

Korea and Japan have been closely linked not only economically but also in many aspects. For example, Japan has been one of the major trading partners of Korea and the volume of trade between the two countries has significantly increased since the development of the Korean economy. Further, there has been a structural transformation in the Korean economy: Korea's capital markets have been extensively integrated to the international financial markets and Korea significantly opened its product markets to the world since the Asian financial crisis in 1997-98 so that the ratios of Korean export and import to its GDP are around 50% as of 2015, respectively. Although all these events point to the direction in favor of a closer integration of product markets, this paper empirically investigates the degree of product market integration between Korea and Japan using a measure of sectoral relative consumer price persistence over the period of 1985-2016. In particular, we examine if sectoral relative prices between the two countries converted with the common currency contain a stochastic trend or converge to their equilibrium value in the long run.

We apply a new econometric method for testing the unit root hypothesis of real exchange rates: we use the panel unit root test in the presence of cross-section dependence developed by Pesaran (2007). His method is to augment the crosssectional averages of lagged levels and first-differences of the individual series in the standard augmented Dickey-Fuller (ADF) regressions to control for crosssection dependence. The use of Pesaran's method has two advantages compared to previous studies.

One advantage is that the method obtains an additional cross-sectional power using panel data and mitigates the well-known shortcoming of univariate unit root tests in terms of their power properties.1 The other advantage is that the method takes into account of cross-section dependence frequently presented in panel data sets. In particular, panels with sectoral real exchange rates are likely exhibit high crosssection dependence since they are constructed using a common nominal exchange rate. The well-known panel unit root tests such as the LLC test developed by Levin et al. (2002), the IPS test by Im et al. (2003), and the Maddala-Wu test by Maddala and Wu (1999) assume that individual time series in the panel are independently distributed across cross-sections. However, O'Connell (1998) shows that the typical panel unit root tests developed under the cross-sectional independence assumption reject too often the unit root hypothesis in the presence of significant cross-section dependence. Further, recent econometric studies show that the method of demeaning the individual series cross-sectionally does not effectively mitigate the problem of cross-section dependence in a general setting. Pesaran's method overcomes this deficiency of the previous tests. Pesaran (2007) also confirms O'Connell (1998)'s finding applying the new econometric method: he examines if the CPI-based real exchange rates constructed using quarterly consumer price indices of 17 OECD countries contain a stochastic trend for the periods of 1974Q1-1998Q4 and 1988Q1-1998Q4, and finds that the IPS test rejects the unit root hypothesis for both cases, while his test developed under the assumption of cross-section dependence does not reject it. He also shows that these opposite results are mainly due to the significant cross-section dependence in those panels. As formally and informally discussed in Section III and IV, the error term of the regression for our panel of sectoral real exchange rates exhibits significant cross-section dependence. Therefore, the use of Pesaran (2007)'s method is appropriate for our study.

We find that sectoral relative prices between Korea and Japan do not revert to their equilibrium value in the long run applying Pesaran (2007)'s panel unit root test. …

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