Real exchange rate behavior and optimum currency area in East Asia: Evidence from Generalized Purchasing Power Parity

Abstract

In the aftermath of the Asian financial crisis, the need for monetary and exchange rate cooperation among the Asian countries has increased considerably. In this context, we attempt to evaluate the potential of an optimum currency area (OCA) for a group of eight East Asian countries. For this purpose, this study tests Purchasing Power Parity (PPP) and Generalized PPP (GPPP) hypothesis, which provides stylized facts of real exchange rate. Specifically, we attempt to investigate the symmetry in macroeconomic disturbances and the co-movements of bilateral real exchange rates of the East Asian countries as one of the standard minimum precondition for forming an OCA. Contrary to many previous studies, we find some supportive evidence for GPPP which, in turn, provides support for the feasibility of an optimum currency area in East Asia. However, the presence of asymmetries in the process, through which countries adjust to shocks in the system, indicates that still higher level of economic integration is required to strengthen the case of a currency union. More importantly, our overall results appear to be invariant to the choice of a base currency and therefore it provides support to the argument that both US dollar and Japanese Yen are important for East Asia while considering the case of a currency union.