Testing the relative purchasing power parity hypothesis: the case of Korea

Abstract

This study examines the relative purchasing power parity (PPP) hypothesis using the data from the Korean won--US dollar and the Korean won--Japanese yen foreign exchange markets. We extract proxies for inflation from stock market returns of Korea, the United States and Japan based on the method used by Chowdhry, Roll and Xia in 2005. We explicitly test the relative PPP hypothesis in light of the short-run price volatility using monthly, bimonthly and quarterly data from 1 January 1998 to 31 December 2012. Our findings suggest that the empirical test results from the entire sample period do not support the relative PPP hypothesis. However, the results from the sample period excluding the Asian Financial Crisis period show that the relative PPP hypothesis holds for the Korean won--US dollar market with a moderate magnitude of inflation impact, but not for the Korean won--Japanese yen market. Abrupt changes in exchange rates during the crisis period may have affected the relationship between inflation and exchange rates. This result also suggests that factors other than inflation might have affected the Korean won--Japanese yen exchange rate.