The Purchasing Power Parity Relationship: Causality and Cointegration Tests Using Korea-U.S. Exchange Rate and Prices

The paper empirically examines the Purchasing Power Parity (PPP) hypothesis using cointegration and causality tests for Korea-U.S. exchange rate and prices. In conducting empirical tests, quarterly time series data were used covering the period from the first quarter of 1971 to the first quarter of 1996. The cointegration tests indicate the existence of a long-run cointegrating relationship between the Korean exchange rate and the domestic vis-a-vis foreign price level. The estimated short-run dynamics suggest that the exchange rate is a stable function of the relative price level with a speed of adjustment of about 24% over a year. This estimated speed of adjustment is somewhat slow but reasonable. Overall, however, the empirical results provide only partial support for the PPP hypothesis for Korea. The causality tests indicate that the causal linkage runs from the exchange rate to relative prices. The latter result is not unusual given that the Korean exchange value was under government control for most of the time period covered in this study.