Purchasing power parity and the impact of the east asian currency crisis

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Discussion Paper

No. 0303

Purchasing Power Parity and the Impact of the East Asian Currency Crisis

Louise Allsopp and Ralf Zurbruegg

March 2003

University of Adelaide Adelaide 5005 Australia

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Purchasing Power Parity and the Impact of the East Asian Currency Crisis

Louise Allsopp and Ralf Zurbruegg

School of Economics University of Adelaide louise.allsopp@adelaide.edu.au

Associate Professor of Finance School of Commerce University of Adelaide Adelaide, Australia 5005 Tel: +61 8 8303 5535 Fax: + 61 8 8303 4368Ralf.Zurbrugg@adelaide.edu.au

March 2003

This paper explores the impact of the East Asian crisis of 1997/98 on foreign exchange markets and purchasing power parity within the region. While many studies have attempted to test for PPP prior to these events, there has been little opportunity to test for this long run phenomenon in the post-crisis period. This study addresses the issue byapplying Inoue (1999) and Johansen, Mosconi and Nielsen (2000) cointegration procedures to bilateral exchange rates deflated using consumer price indices. Along with endogenously determining a structural break at the time of the crisis, the empirical results shed light upon the significance of the East Asian crisis on long-run PPP within the region. The findings are generally supportive of PPP with thecrisis leading to only shifts in long-run trends. However, the results are not homogenous across all countries which is partially attributed to how individual countries handled the crisis.

JEL Codes: F31, F41, C22 Keywords: Cointegration, Exchange Rates, Purchasing Power Parity


1. Introduction Although a considerable amount of literature exists on the causes of the 1997 Asian currencycrisis [de Brouwer (1999), McLeod and Garnaut (1998) and Krugman (1998)] and also on market integration and long run relationships between various Asian capital markets prior to the crisis [Phylaktis (1999) and Hsieh, Lin and Swanson (1999)], very little research to date has examined the impact of the crisis on the long term dynamics of the East Asian foreign exchange market. There are two basicreasons for this current lack of research. First, in order to determine the long run impact of the crisis upon foreign exchange realignment, a sufficient time period needs to elapse before a reliable analysis can take place. Second, to examine long run stochastic trends of FX rates where a crisis has impacted upon these markets requires research methods that account for structural breaks and...