Real and Monetary Causes of Real Exchange Rate Movements in the Pacific Rim

Modem models of exchange rate determination suggest that real shocks can induce changes in the real exchange rate; a real shock which is permanent can induce a permanent deviation from Purchasing Power Parity (PPP). Nominal shocks, on the other hand, can induce temporary but not permanent deviations from PPP. Even if money is not neutral in the short-run, long-run money neutrality guarantees that monetary shocks of any variety have no permanent effects on the long-run value of the real exchange rate. For example, in the well-known Dornbusch [4] overshooting-model, an increase in the money supply initially causes real and nominal exchange rate depreciation. Over time, the real rate converges to its original level and the proportional change in the nominal rate approaches the percentage change in the money supply. To date, the vast majority of tests concerning PPP have been conducted for the U.S., European, and Japanese economies; most of these tests are not supportive of the hypothesis. For example, Corbae and Ouliaris [1] and Enders [5] use unit-root and co-integration tests to reject PPP for this group of nations. However, as shown by Mussa [9] and Enders [6], PPP works quite well for nations experiencing very different rates of inflation. These findings are consistent with the theoretical models of the exchange rate if the industrialized nations experience permanent real shocks while the high inflation nations experience substantial monetary growth. In this light, it is interesting to consider behavior of the real exchange rate for the Pacific Rim nations. These nations-particularly Japan and Korea-represent rapidly growing nations with strong trading ties to the United States and Europe. Comparing of the behavior of the real exchange rate between Japan and Korea (two rapidly growing nations) might provide an interesting contrast to that of Korea versus other Pacific Rim nations and Korea versus the United States.