Do Prices Determine Exchange Rate? -The Japanese Evidence for Purchasing Power Parity-

Abstract

The longtime perplexing purchasing power parity(PPP) puz-zle has been recently resolved empirically by a pioneering financial-asset pricing approach. Applying the same extracted inflation rates, we estimate a vector error-correction(VEC) model of prices and the Japanese yen per U.S. dollar exchange rate, and find strong evidence supportive of (i) the PPP restriction which yields the equilibrium error in the form of a real exchange rate. Further, documented under the PPP relationship so detected are (ii) the impulse responses of exchange rate to prices and between prices that would imply exchange rates channeling inflations into coun-tries, and (iii) the impulse responses of prices to exchange rate (i.e.,exchange rate effects on prices) that would usefully indicate the degree of exchange rate pass-through by Japanese exporters. Together, the findings lend, in the VEC context, desired PPP-theoretic content to the pure inflation rate estimates used.