Productivity Differentials and Purchasing Power Parity: Cases of Indonesia and Korea

This paper provides a test of purchasing power parity (PPP) adjusted with the productivity differentials between tradable and non-tradable goods (Balassa-Samuelson effect) in the cases of Indonesia and Korea by applying Johansen cointegration test and a multivariable regression model with quarterly data 1971:I-2005:III. Least squares (LS) and autoregressive conditional heteroskedasticity (ARCH) methods are applied to estimate the model. To consider the foreign exchange regimes and the Asian currency crisis, this paper divides the analysis into two sub-samples i.e. ‘before crisis’ (1971:I-1997:II) and ‘after crisis’ (1999:I-2005:III). The analysis yields some conclusions. First, Johansen cointegration test confirms the long run equilibrium relation between foreign exchange and inflation rates. Second, the PPP hypothesis (symmetry and proportionality restrictions) does not hold and the Balassa-Samuelson effect significantly exists in the case of Indonesia for the both sub-samples ‘before crisis’ and ‘after crisis’. Third, the PPP hypothesis also does not hold and the Balassa-Samuelson effect does not exist in the case of Korea for the sub-sample ‘before crisis’. Korea exhibits a deviation against the PPP hypothesis for the sub-sample ‘after crisis’.