Academic journal article East Asian Economic Review

Inter-Region Relative Price Convergence in Korea *

Academic journal article East Asian Economic Review

Inter-Region Relative Price Convergence in Korea *

Article excerpt

(ProQuest: ... denotes formulae omitted.)

I.INTRODUCTION

Purchasing power parity (PPP), which is one of major building blocks in international macroeconomic models, states that both home and foreign aggregate price levels should equal at the equilibrium once converted to a common currency. The underlying mechanism behind PPP is that international good market arbitrage enforces broad parity in prices of individual goods and services. Of course, the effectiveness of international arbitrage depends on the degree of integration between national markets. Therefore, PPP implies that both home and foreign national markets are completely integrated. However, it is natural to observe deviations from PPP in real world considering various barriers to complete relative price-level adjustment. Instead, previous studies ask if deviations from PPP reflected in real exchange rates converge to the long run equilibrium value. If so, how quickly do they move back to it, in response to a shock to the prices?

Numerous studies have conducted the tests for PPP using various econometric methods and data sets. In general, the consensus of those previous studies is that real exchange rates converge to PPP in the long run.1 However, the speed of convergence of the real exchange rates is very slow: half-lives of deviations from PPP are in the range of 3 to 5 years. See, for example, Rogoff (1996), Frankel and Rose (1996), Murray and Papell (2005), and Choi et al. (2006). This slow speed is not compatible with the predictions of monetary models such as Mundell-FlemingDornbusch models and sticky price dynamic stochastic general equilibrium models. Those models can generate the volatility of real exchange rates consistent with data [see, for example, Chari, et al. (2002)]. However, those models should assume that prices are fixed about more than 3 years, if they intend to generate the strong persistence of the real exchange rates consistent with the speed of mean reversion in data. However, this assumption is unrealistic. Previous studies call these two apparently incompatible empirical findings the PPP puzzle [see, for example, Rogoff (1996)].

Based on such empirical evidence, studies have looked for sources that affect persistence in a deviation from PPP. Those sources include: (i) incomplete price level adjustment due to price stickiness (ii) the presence of non-tradable goods in the aggregate consumer price index; (iii) transportation costs; (iv) the influence of flexible exchange rates; (v) international trade barriers such as tariffs and non-tariff barriers. Each of these components affects the transitional dynamics of real exchange rates. In particular, the last two explanations are closely related to the socalled border effect, although one cannot precisely distinguish the effect of each component from others. For example, Engel and Rogers (1996) present evidence that both distance (which proxies the effect of transportation costs) and borders (which proxy the effects of exchange rates as well as of international trade barriers) explain significant proportions of deviations from PPP. During the floating exchange rate era, studies notice that nominal exchange rates combined with sticky prices affect deviations from PPP. Note that if prices of goods and services are sticky in both countries, the behavior of nominal exchange rates is very similar to that of real exchange rates. For example, Mussa (1986) and Engel (1993) present evidence that the volatility of real exchange rate changes is quite similar to that of nominal exchange rate changes during the floating exchange rate era, and attribute it to sluggish price adjustment. Betts and Devereux (1996) and Engel and Rogers (2001) also emphasize the effect of variable nominal exchange rates under local currency pricing on deviations from PPP, while controlling for the effects of international trade barriers.

This paper uses relative consumer price indices for 15 regions in Korea including 6 metropolitan cities and 9 provinces over the period of 1990-2016 and ask the same questions as previous studies. …

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