UCLA Anderson School of Management Working Paper Series Impulse Responses of Exchange Rate and Prices under Purchasing Power Parity: Japanese Evidence from An Extracted Inflation-Based Study

The longtime perplexing purchasing power parity (PPP) puzzle has been recently resolved empirically by using the pure price inflation rates extracted and estimated 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. Documented, further, under the PPP relationship so detected are (ii) the impulse responses of exchange rate to prices and those of prices to exchange rate that would imply exchange rates channeling inflation of one country into another country. Together, the findings lend, in the VEC context, desired PPP-theoretic content to the pure inflation rate estimates used.