Japan and Korea are close countries in terms of economic interaction as well as geography. To quantify the impact of changes in the yen/dollar exchange rate and Japanese industrial production on the Korean economy before and after the crisis in 1997, the sample period is divided into two sub-periods and then the causal relationships are examined by using vector autoregression analysis. Our estimates show that while the response of Korean industrial production to changes in the yen/dollar exchange rate is not significant during the pre-crisis period, it becomes significant during the post crisis-period. The forecast error variance decomposition also confirms that the yen/dollar exchange rate shocks have almost negligible explanatory power with regards to Korean industrial production during the pre-crisis period, but they have some significance for the post-crisis period. These empirical results show that the free floating exchange rate regime adopted since the crisis cannot insulate the Korean economy from external nominal shocks such as the yen/dollar exchange rate shocks.

Executive Summary

I. Introduction

II. Economic Interdependence between Japan and Korea
1. Co-movement of the Business Cycles
2. Co-movement of Exchange Rates

III. Empirical Tests
1. Some Basic Statistical Relations
2. Stationarity Test and VAR Impulse Response Analysis
3. Variance Decomposition

IV. Conclusions

Appendix

References