Does Inflation Targeting Policy Matter for Purchasing Power Parity?: The Case of South Korea

Purchasing Power Parity (PPP) posits that the purchasing power of a currency equals that of another when converted into the other currency. However, PPP often fails due to the high volatility of nominal exchange rates across countries. The implementation of inflation targeting (IT) would be vital in reducing this volatility, attributed to its features of transparency and accountability, which decrease uncertainty in inflation expectations. Therefore, I expect to observe more supportive evidence of PPP for countries implementing inflation targeting (IT) policy. Using the Smooth Threshold Autoregressive (STAR) model covering January 1990 to December 2023, I examine whether IT policy positively affect PPP between South Korea and its fourteen major trading partners. Comparing the supportive evidence of PPP between seven inflation targeters and South Korea versus seven non-inflation targeters and South Korea, as well as pre- and post-IT policy periods among the seven inflation targeters, I find that IT policy may have positive effects on PPP. Especially, the findings indicate greater supportive evidence of PPP after IT policy implementation among developed inflation targeters, implying potentially higher credibility of their central banks. This suggests that IT policy may achieve greater success in developed economies compared to developing ones.