Output, Inflation, and the Balance of Payments in a Small, Fixed-Exchange Rate Economy: Tests with Data for Korea, 1960-1973

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Number 64 OUTPUT, INFLATION, AND THE BALANCE OF PAYMENTS . AW A SMALL, FIXED- FEACHA IGE RATE ECONGIAY: Tesis with Data for Korea, 1990-1973

by Sung Y. Kwack

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| 1 { \ . July 2, 1975 |

OUTPUT, INFLATION, AND THE BALANCE OF PAYMENTS IN A SMALL, FIXED-EXCHANGE RATE ECONOMY: TESTS WITH DATA FOR KOREA, 1960-1973.

by

| a a Sung Y. Kwack

NOTE: International Finance Discussion Papers are preliminary materials circulated to stimulate discussion and critical com- . ment. References in publications to International Finance Discussion Papers (other than an acknowledgement by a writer that - 7 he has had access to unpublished material) should be cleared with the author or authors.

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Output, Inflation, and the Balance of Payments ina Small, - Fixed-Exchange Rate Economy: Tests with Data for Korea, 1960-1973

by Sung Y. Kwack*

Increasing interdependence among economies in recent years has stimulated the development of models that take account of such interdependence in order to more adequately analyze an individual country's economic activity and inflation. At the same time, the effects of : fiscal, monetary, and exchange rate policies in a small open economy

on its output, inflation and balance of payments have been discussed at

1 . oe «os an abstract level. Little systematic empirical work has yet

been undertaken to examine the interesting implications emerging from these recent theoretical developments. In this paper, an attempt is made to provide an econometric framework explicitly allowing for ex~ ternal transactions of goods, services, and financial assets and for’ the dependence of monetary changes on fiscal deficits and the balance of

payments. The model is applied to a highly open but small econony, the

Republic of Korea, to demonstrate the usefulness of this framework.

The first. section discusses the econometric model of Korea estimated

_over the periods 1960-1973. Then, prediction errors of dynamic simulations

.within the sample period and outside the sample period, 1974, are presented.

The second section employs dynamic simulations from 1966 through 1970 to

focus on the effects over time of changes in domestic fiscal and monetary

policies, foreign activity, and the exchange rate. The paper is concluded

in the third section with a summary of the main results.

This paper represents the views of the author and should not be interpreted as reflecting the views of the Board of Governors of the Federal Reserve System or other members of its staff.

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‘I. A Model of the Korean Economy

The Korean model reported in this paper is constructed with the

‘following main assumptions about the economy: (a) it engages in trans-

“actions with the rest of the world in both goods and services, and

q

assets; (b) the size is small in the sense that the price levels ‘and. activities abroad are given; (c) the domestic and foreign assets aré perfect substitutes for each other: and (a) the banking system passively accommodates the needs‘ for financing the government deficits ‘and takes

no sterilization operations to offset the effects of changes in inter-

‘national reserves on the money supply. The Korean model contains 13 _

behavioral and 13 identity equations; 17 exogenous variables. uniquely determine the movements of the 26 endogenous variables, The 13 sectoral ‘equations explain the behavior of consumption, investment, exports,

imports, demand for money, transfer receipts from abroad, net factor

"income from abroad, taxes, and prices. - The model is closed with 13

identities determining aggregate activity, money supply, and the balance

of payments, and defining aggregate foreign activity, foreign prices,

and an effective exchange rate. Figure 1 is a flow chart of the model

‘which shows the interrelationships among various sectors of the economy.

parentheses under the estimated coefficients are t-statistics; and R’,

The structural coefficients of each equation in the model are

- estimated, using ordinary least squares, with annual data over the

2

“period 1960 through 1973. Consequently, estimates of the structural

coefficients are subject to simultaneous equation bias. The figures in

2

~3-

oe Figure 1 Lo SIMPLIFIED FLOW CHART OF THE MODEL

GOVT. FOREIGH * EXPENDITURES CAPITAL

TAXES

emcee sate hatens Arent setae i ES t eRA CARD Brn ee o eee

* FOREIGN REAL GNP AKO PRICES

NET EXPORTS OF Gocos

{ e .- . . . . *. : 1, The variables in <> arc exogenous variables, : "+ * 2 Arrows ( ) indicate the directions of main influence, “ }

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Sn En” ae

oem treme rem mem ST RENO CS RR RNR mE LO ER REE ENT) HONE ORME BO RE RN km ma eA ~ ae ym at ns

| ; _ "Equation (3) determines the quantity of real exports. In addition — {

-4- SEE, and DW stand for the coefficients of determination adjusted for degrees of freedom, the standard error of estimate, and the Durbin-Watson

statistic, respectively. ‘The sources of data used are the Bank of . | ‘Japan’ C1], the Bank of Korea ion Board of Governors of the Federal Reserve System (51, International Monetary Fund [15], and the U. S.

oan

- Department ‘of ‘Commerce [26].

Table 1 presents the estimated equations, identities, and definition of symbols.> Real private consumption expenditures as given in Q) is. ‘ assumed to depend upon real net national product and private transfer : receipts excluding taxes. The income elasticity of real consumption is estimated at about 0.9, which seens to be acceptable. Real private net domestic investment’ flow (including changes in inventories), as given in : (2), is determined by changes in real domestic product and changes in | private borrowings from the domestic banking system and abroad. The increase in private borrowings directly raises the speed of adjustment of the existing stock to desired levels through increasing the availability of funds and indirectly represents the reduction in the rate of interest on borrowed funds through increasing the supply of funds. In - both cases, its effect on domestic investment inflow is expected to be | | positive and is found to spread over a 4 year period. However,.

measures of the cost of capital are not included because of inadequate .

information on the after-tax rate of return or market interest rates.

to foreign real income and relative prices, the lending by the domestic

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Table 1

A Small Open Economy Model: Korea, 1960-1973

I. BEHAVIORAL EQUATIONS

(1) Private consumption expenditures

cP log (<-) = 0.625 + 0.426 log(y,) + 0.473 log(y)_) (6.54) (3.26) 3.40) | R* = 0.997 SEE = 0.025 DW = 3.202 (2) Net private investment expenditures gq? a P P + ae ~12.493 + 0.569 ies + 0. yoy toa? +e? (2.86) (11.42) _ 63.83) ; as Po PP ANDA” + AFK . + AF + 0.169[-——-1_, + 0.113, (8.95) (3.61) oe P,P + AFK + 0.056 [ee (1.95) R’ = 0.987 SEE = 9.796 ‘DW = 1.916

(3) Exports of goods and services, excluding factor income

) + 0.007 BBE

log E%) = -4.978 + 1.546 ‘los (y PM GAD

PX" (4.383) (2.12) f

=— 0.695 log (a D - 0. _760 Log (se 2 ~ 0.771 log (—.

xy (1.93) (2.40) -1 (2.77) PR°E’

= 0.727 108 FE ) = 0.628 log (x. ) (3.05) FE -3 (3.24) ED,

= 0.473 tog PX) - 0.264 log x G37) PRE’ 5 (3.45) PRE’ 6

= 0.997 SEE = 0.067 DW = 1.487 -

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(4) Imports of goods and services, excluding factor income

PP ana? Bi pk Pp 7 75.607 + 3.088 log(© NE ACCA +140", (18.65) (7.84)

log G- Ho, PP P g. g - 1.533 log (© +NI fee +1°+C ) (3. 79) -]

~ 0. 306 ‘tog - 0. 229 lop Et ") (3.35) (3. 35) Pl

- = 0,153 log 75) ~ 0.076 12 » (3.35) P =2 (3.35)

2 = 0.991 SEE = 0,078 DW = 2.347

(5) Net factor income receipts from abroad

pone ~ ~13.039 + 0,154 y, ~ 0.033 cae + 0.747 Cour) (2.57) (3.49) (4.32) (5.71) = 0.942 SEE =1.774 DW= 2.110 (6) Private transfer receipts from abroad op NTR) = -8.678 + 1.996 log(y,) (5.38) (6.87) R? = 0.781 SEE = 0.315 DW = 0.596

(7) Taxes, net of private transfer receipts for current and capital expenditures from government

TNTR = 8.464 + 0.115 (GNP-+IN-CCA?- con®) 0. 48) (17.67)

R- = 0.960 SEE = 44. 019 DW = 0,718

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(8) Demand for money (M2)

MS ‘ . ee log (HS) = ~6.953 + 1.833 10g(CMe) + 1,718 RI ~~” PRGNP (22.64) (41.65) PNP (3.44) 21,595 logge) - 1.162 log Gan SE) -3 (4.25) -1 (7.19) -1 7} "= 0.999 log Ge -)_5 - 0.894 log@ae—)_, (5.27) ~1 (5.13) rl - 0.632 log(eee—)_, | (3.82). -1 R= 0.995 - ‘SEE = 0.076 DW = 2.573

(9) ‘Wholesale prices

log(P) = 0.413 + 0.142 log(WR) +.0.349 log(PM) + 0.256 log (PR)

(2,38) (2.35) (3.71), (1.83) GDP + 0.785 [log (=) - log K] (2.48) PGNP ° 2. 0.991 SEE = 0.044 DW = 1.638

(10) Wage rate

log(WR) = -10.694 + 1.679 log K + 0.268.log RT ~ 2.836 log N

(13.2) (12.7) (4.82) (1.84) + 0.601 log (PGNP) (3.04) R? = 0.999 SEE = 0.030 DW = 2.457

(11) Export prices

log(PX) = 1.618 + 1.198 log(P) - 0.243 log K

(2.24) (11.4) (2.26) = 0.979 SEE = 0.068 DY = 1.391

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(12) Import prices

log(PM) = 0.016 + 0.807 log (PFX) —_ - (0.84) (36.2) a an RK = 0.990 SEE = 0.050 ‘DW = 1.301

(13) Government's capital consumption allowance

g - Ce = 0,851 + 0.003 K_, (2.47) (10.5) R? = 0.894 SEE = 0.515 DW = 1.827

II. ‘IDENTITIES

(14) Private capital consumption allowance :

g CCA _ CCA p= 0004 Ko

(15) Capital stock

BS peak np , 18 — cca® |

Kept 5 P Ry

. (16) Gross domestic expenditures

cpp = cP + nz? + cca? + 18 + c8 + EX - IM

(17) Gross national expenditures

GNP -= GDP + NYF

(18) Real disposable income, net of depreciation, taxes and transfer

receipts ae = GNP + PNTR, TNTR Ya ~~ pGNP ~ 0.04 Ky ~ penp

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(19) Implicit GNP deflator cant? + ccaP + 18 4+ cB EX OM

PGNP = GDP / (> + Px 7 FH .

(20) Supply of money including time and savings deposits

Ms = NDA’ + NDA® + NFA

(21) Change in the banking system's investment and lending to government

anpa® = c® + 18 ~ cca® - tyre - cntR - aFK®

(22) Change in the banking system's net foreign assets

ANFA = EX ~- IM + NYF + GNTR + PNTR + arK® + ark’

- (23) Foreign real income

_ 0.5 an 0.5 ¥_ = CXNP,. ) (ANP 5 0.027663)

(24) Implicit exchange rate index

- EKO , “EJA_.0.5 E = 730 (.27663)

(25) _ Foreign wholesale prices

PF = (P 0-5 (p 0.5

US i”

(26) Foreign export prices

PFX = (PX) 9 PK, 49°?

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- ITI. DEFINITIONS (* indicates exogenous variable)

*c& = Government consumption expenditures, billions of Won cP = Private consumption expenditures, billions of Won . -cca® = Government capital consumption allowance, billions of Won cca’ = Private capital consumption allowance, billions of Won | - a *DBF = Banking system's loans for support of exports, end of year,

billions of Won

E = Implicit effective exchange rate index, 1963 = 1.00

EX = Exports of goods and services, excluding factor income, billions of Won

*EJA = U.S. cents per Japanese yen *EKO = Korean Wons per U.S. dollar *pK® = Government borrowings from abroad, end of year, billions of Won , FKP = Private borrowings from abroad, end of year, billions of Won GDP = Gross domestic expenditures, billions of Won GNP = Gross national product, billions of Won . AONTR = Government's transfer. receipts. from abroad, billions of Won cs = Government's gross domestic investment, billions of Won IM = Imports of goods and services, excluding factor income, K = Physical capital stock, end of year, billions of Won MS = Money supply (Ml + time & saving deposits), end of year, billions of Won npa® = Banking ‘system's investment and lending to government, end of year, billions of Won ‘ . supa? = Banking system's investments and lending to domestic private, .

end of year, billions of Won

NFA = Banking system's net foreign assets, end of year, billions , of Won . *N = Population index, 1963 = 1.00

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nna nn OE On ne ecorsehtieamnemeniatensebemamutitabemnamemetemenstenernemnmetian .

ni? = Private net investment expenditures, billions of Won . NYF. = Net factor income receipts from abroad, billions of Won PF Wholesale price index for all commodities, 1963 = 1.00 7 | . *P oa = Japanese wholesale price index for industrial products, 1963 = 1.00 *Pis = U.S. wholesale price index for industrial products, 1963 = 1.00 PF = Foreign wholesale price index, 1963 = 1.00 PFX | = Foreign export price index, 1963 = 1.00 PGNP = Implicit GNP deflator, 1963 = 1.00 PM. = Implicit price deflator of imports, 1963 = 1. 00 PNTR = Private transfer receipts from abroad, billions of Won “=. + SPR = Wholesale price index for grains, electric power, and tobacco PX = Implicit price deflator of exports, 1963 = 1.00 *PX 54 = Japanese export price index, 1963 = 1.00 *PX ig = U.S. export price index, 1963 = 1.00 ART = Interest rate on time deposits, :fraction TNIR = Taxes, net of private transfer receipts for current ‘and capital expenditures from governments, billions of Won wR = Manufacturing wage index, 1963 = 1.00 *XNP = Japanese real GNP, billions of 1963 Yen AXNP (= U.S. real GNP, billions of 1963 dollar Yq _ Real disposable income, billions of 1963 Won . Ve ‘= Foreign real GNP, billions of 1963 dollar .

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-12~

banking system to the private sector for the promotion of exports (DBF) has a positive effect. The long-run price elasticity is about 4, whereas

the impact price elasticity is 0.7. This is not surprising because most «

Korean exportables are non-raw materials and non-agricultural goods, and the

estimates are consistent with the price elasticity estimates of U.S.

imports. Conversely, the quantity of real imports is price-inelastic

even in the long-run, as indicated in equation (4). ‘This appears to be in line with the prior supposition that imports of raw material and

agriculture goods are not very substitutible. The long-run income elasti-

city of imports, 1.5, turns out to be lower than the short-run elasticity,

3.0. . Although the long-run elasticity estimate is acceptable, the short-run elasticity estimate is quite high. This may call for some improvement in the specification. | |

Equation (5) shows the positive relationship between net factor income abroad and economic activity in the current and previous periods. Also, private transfer receipts from abroad, given in (6), are assumed to relate positively to foreign activity. Not surprisingly, the transfer receipts are sensitive to variations in business conditions abroad. Equation (7). describes private taxes net of current and capital transfer receipts

from government. Given tax rates, the taxes net of transfer

receipts aré postulated to depend on the tax base, measured by nominal

a

GNP and imports net of capital depreciation.

In equation (8), the demand for real money inclusive of time and

_ savingsdeposits is a function of real GNP, a 5 year distributed lag func-

tion of inflation rates, and the interest rate on time and savings deposits.

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-13-

.e *

The deposit rate is fixed exogenously by the monetary authority. The

effect on money demand from a change in the deposit rate is a priori inde-

terminate because an increase in the deposit. rate leads to.an increase in

the demand for the time and savings deposits and also a decrease in the

demand for currency and demand deposits. Nevertheless, the empirical

finding of the positive effect indicates that a rise in the deposit rate

generates a rise in the money balance, thus providing an increased supply

’ of funds available for private investment.° _The importance of private

wealth is ignored because of the lack of quantitative information on

financial wealth.

As shown in equation (9),

the whplesale price index is determined

by the wage rate; import price; wholesale prices of grain, electric |

power and tobacco set exogenously by the government; and the capacity

utilization rate represented by the ratio of real GDP to the capital

stock. The wage rate is assumed to be flexible and determined by the

price level and the demand for labor in excess of the labor supply .§ Labor

demand is positively related to the capital stock and the ratio of the

deposit rate to the wage rate.

A profit-maximizing substitution between

labor and capital with given relative factor prices is assumed, noting

that labor is the abundant factor and cost of capital is partially repre-

sented by the interest rate. Equations (9) and (10) together imply

that price levels and wage rates are simultaneously determined by both

foreign forces-—import prices-~and domestic forces~-the capacity utili-

zation rate, the capital stock and the interest rate,’ The export price

in (11) is assumed to be associated positively with domestic price and

negatively associated with the capacity to produce exportables. The

ORAM PRENTTT TRAYS DETR OTNPNI TYME THESE ENTE Os. CRN:

ee ee

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|

|

j ad he

. ~14~ -

- gmall country is not completely a price taker in.selling its goods and

services. But, the country is assumed to be a price taker. in purchasing

. foreign goods and services. Hence, the import price as given in (12)

is determined by foreign export prices adjusted for exchange rate

-variation.

Equations (13)~(15) define the rate of depreciation of physical capital stock as 4% per year, Equations (16) through (19) provide definitions of several measures of domestic activity and the implicit GNP price deflator. Equations (20)-(22) define the sources of increases in the money supply as autonomous increases in the bank's lending to the private sector, financing of government, fiscal deficits, and increases in net foreign assets. Changes in nominal money demand are determined by equation (8), and the bank lending to the private sector is a policy

instrument. Thus, equating money demand and supply implies that the

‘balance of payments identity (22) can be used for determining changes in

‘the private borrowings from abroad. This shows that conditions in the

money market play an important role in determining the capital inflows as well as the balance of payments. ‘This approach to explaining capital

flows is conceptually equivalent to the conventional approach of pre-

- dicting capital flows from the demand for foreign assets, as shown in

Appendix 1.8

Equations, (24)~(27) define aggregate foreign income, wholesale

_ prices, export price, and the effective exchange rate. The weight 0.5

given to the United States is based on the relative value shares of

exports and imports.

-15-

_ Table 2

Qynamic Prediction Error Analysis

Within the Sample Period,

1960-1973

Outside the Samp 1974

le Period,

rrr RO a EE = Pre yee

RMSE as Z of

PGNP Pp PX PM WR cPy/p

_ nt?yp

EX/PX IM/Pu GDP/PGNP GNP /PGNP EX

IM EX-IM GDP

GNP

ANFA

anpa®

AMS

MB .

-0.02 --0.01 -0.02 0.01

— 0.06

-5.78 9.95 1.33 -8.07 -8.74 ~3.78 ~13.86 ~14.48 0.62

-=38.15

-37.60

~ ~13.00

5.95 ~-7.06

RMSE as Z% of Actual Mean

3.62 —

_ 3.40 7.34 4.20

11.04 4.58

34.40

16.31

10.90 5.79 “5.49

25.90 7.77

~59.17 7.52 7.17

451.10

1788.49 54.68

MB

-0.29 0.46 -0.55 ~1.28 1.46 226.56 ~61.62 160.85 85.46 238.55 225.85 246.24 | -280.78

527.02

225.09 189.05 794.31 -377.95 416.36

8.04 11.33 14.07 22.52 16.28 18.77 16.45 30.17 16.62 12.23 11.70 11.86

9.64

_ ~63.09

3.21 2.72 ~165. 76 -465.80 92.16

Actual Mean

MB (MEAN BIAS) is £ (solved - actual)/N and RMSE (ROOT MEAN SQUARED ERROR)

is [£ (solved ~ actual)? /n}9°5

’

Prices are expressed in 1963 = 1.0, whereas all other variables are in billions of Won.

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where N is a number of observations (N = 14).

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~16-

The adequacy of the model for policy analysis is provided by the predictive ability of the system of equations as a whole. Tests of predictive ability are based on the results from dynamic simulations within and outside the sample period. The statistics of mean bias and root

mean squared error as % of actual mean for the major endogenous variables

_are presented in Table 2. The equation explaining the government deficit

financing (anpa®). seens to perform poorly and causes substantial errors in explaining changes in net foreign assets as well. This is also confirmed in the prediction outside the sample period for 1974. Since the values of all the exogenous variables used for 1974 are actual values, the mean bias is the prediction error. For 1974, the model predicts price levels lower than the actual and levels of real activity higher than actual. As a result, the errors for. the nominal values of GDP and GNP are very small and amount to about 3% of actual values. In addition,

the actual and predicted values for real GNP, the implicit GNP deflator,

nominal exports and nominal imports of commodities and services excluding

factor income are plotted in Figures 2-5, respectively. Considering that the predicted value of exports for 1973 is substantially lower due to a reduction in the real volume of loans for export promotion induced by increased import prices, these figures reveal that the system as a whole adequately traces the actual performance of the Korean economy. Thus, the model is deemed acceptable as a tool for the simulation exer-

cises of the following section. : ee oe

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3 FICURE 2:SCTUAL ANO PREOICTED VALUES OF REAL CNP a

o at

NV. : ee . : a nn ee a ™

~N 7 . CC rs rT : Ty" : g } GNP/PONP | _

[| 0 @ = — © GNPYPGNP(EST) | | 7 ; 2 . 7 Te, bes 2) SS :

o . So ; “7 :

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‘

nate

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-FIGURE 3°ACTUAL AND

. oO ret @———-© PGNP G — — © PGNP (EST) nN Oo N oOo iy 4 «~ ~ et Pr] Orn oO wa i fos} ~ " ; 1960 1951 1962 1963 i964 : KOREAN MCOEL JUNE 12, 1975

—

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re ST NE SR NY ORRIN Rem oS re: en PRI ETE © = ee eereryreree me eee fie tay w arte wee

-~]9~—

e000.

G- — — © EXtEST)

16c0.

a oS . N . i, iv i) / Co (os) af . > —_ cD 7, wee ; “oe ae , : . , ran) “ | 3 (aD) o yf . - ar tr 2 - — ' . or Ter _ . $= e a e a

Ae a en ee ee reer se

1960 1961 1962 1963 i9G¥ 1965 1966 1967 1968 1969 1970 i971 1972 1973 °

JUNE 12, 1975

FIGURE 4:ACTUAL AND PREDICTED VALUES CF EXPORTS —

bal octliateenthaiedemertntahintirenetnentnteatetentie ot tachi ciaaatedt hem teehee ie wienten den on niall n Dnata ortinah haainricenheeades at deatanaimndaeeammntetaen tine tiadnet nena

ee ee cee ne cee nen 2 ain ener ee ge MAE RPS 9 OTERO tA AAT RCRA A th A: ete NAN OT TREE OCC A CE

~20-

WON

OF

BILLIGNS

1600.

cco.

ecoo.

Pa

¢——— IM eo — —© IM(EST)

i)

(!

w

-—

cm) ro)

iced.

_

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80C.

yoo.

1971 1972 1973

KCREAN MODEL eran ; .

.

co

NOL RO AE BOO etek NR RRS RE eee em Rane Ree RE yen mt ate .

7 Ra pry fae re Ste Sere omen alee qe ae rte eyt Hie Regma pt rt gt

. . i fs

Lome

Sa eel Rn EES aR, OS ES COR ee ee CONTR COE Ty, COOP DUROU MEEDE TSS CROMER LENCO ar ow BV SRT Ss RE

~21~

JI. Simulation of the Model

Thus far, the equation specifications underlying the model have been examined. To investigate the effects of fiscal, monetary, and exchange rate policies, dynamic simulations are conducted over the period 1966-1970. In each simulation with an exogenously originated shock, all other exogenous variables remain unchanged. Thus, the differences between the shocked and the control solution estimate the responses of the model. Values of the responses over time are reported for five exogenous changes: ? (a) a 15 billion won sustained increase in nominal government expenditures, (b) a 5 percentage point rise in the time deposit rate, (c) a 3 billion won sustained increase in bank lending to the domestic private sector, (d) a $70 billion sustained increase in U.S. real GNP and (e) a 10% sustained devaluation of the Korean won against the U.S. dollar. The model is “nonlinear and simultaneous. Consequently, the magnitudes of the responses are sensitive to the time when the change in an exogenous variable is initiated as well as the magnitude of the shock.

The first three shocks represent changes in fiscal and monetary policies. The effects of these changes on output, prices, and external transactions obtained by the simulations are summarized in Table 3. As can be seen, the autonomous change in nominal government expenditures

raises real GNP by about 7 billion won initially and by about 10 billion .

won after 5 years. The greatest response of the economy occurs at the

second year, and the impact seems to decline thereafter. Over the 5-

year path, the response to a change in government expenditures appears to be low. This is plausible, however, because the government deficit

causes a substantial deficit in the external balance of goods and services

RT TE EE TS MET CN TN TF NTE ETE LE a EE A NE TR CT ON IT A TMT LEETRE ET! ETTORE TOS

ae a ee reenter oo

-22-

Table 3

Time Path of the Effects of an Increase in Government Expenditure, Time Deposit Interest Rate, and Domestic Monetary Expansion

__K P CNP/PCNP_ aE IM EX-IM ss __ANFA 15 billion increase in government spending (a(c®+18) ) ist yr. 8.364 0.461 7.312 0.110 #£=16.690 -16.580 -8.359 2nd yr. 15.936 0.657 13.009 -0.202 11.019 -11.220 -6.271 3rd yr. 19.559 0.332 12.106 -1.201 8.936 ~10.137 ~7.262 4th yr. 22.556 0.045 10.410 -1.835 9.326 ~11.160 -8.939

Sth yr. 26.107 -0.099 10.081 -1.635 °° 10.814 © -12.449 ~9.431

. 5 percentage point increase in time deposit rate (ART)

Ist yr. 1.999 0.648 0.248 0.232 2.039 -1.807 15.597

0 2nd yr. 5.309 0.540 9.833 ~0.609 3.094 -3.703 - 10.084 3rd yr. 10.371 0.387 1.419 -1.790 5.420 -7.210 — 16.470 4th yr. 18.062 0.290 2.561 -2.925 9.254 -12.179 23.859 5th yr. 28.482 0.207 4.963 -3.987 13.417 ~17.403 °° —- 28.016 ; . px 3 billion increase in bank lending to private (ANDA ) . . lst yr. -0.001 0.0 0.001 0.010 0.003 0.007 -2.999 2nd yr. 0.013 0.0 0.023 0.032 ° 0.023 0.008 -2.981 3rd yr. 0.016 0.0 0.043 0.056 0.007 0.049 -2.963 4th yr. 0.016 0.0 0.048 0.087 0.039 0.048 " =2.961 Sth yr. 0.023 0.0

0.064 © 0.122 0.057 0.065 ~2.932

-_

Government expenditure, time and savings deposit rate, and the change in bank lending to the private sector were individually shocked and dynamic simulations were run from 1966-1970. *ADBF (loans for exports) is also increased by 0.027 billion. 7

P is the wholesale price index (in percent of the price index before the shock occurred; GNP/PGNP is real GNP; EX is. export value of goods and services; IM is import value of goods and services; and ANFA is change in net foreign assets;

K is capital. stock (all in billion of Won).

ete aia linin aceite ald eelabentin Innes eed Le Tat eh ses hated neh Loe mate ee ae

way ures oy wr rogers”

oe ae

a ee tt deh ee ee

on a en re earn teeta Sete RRR ee inline tate ee ann cent nel etn att mannan Httneetnlt Rn NCA MRL In dn LtNtne vam git on ot

Oo ~23~

amounting to 11 billion won and a rise of the wholesale price by about

0.3 percent. As expected, the rise in government expenditures leads to

a deficit cf about 8 billion won in the balance of payments, although

there are foreign capital inflows of about 2 billion won on the average. Let the monetary authority permit a 5 percentage point rise in the

rate on time deposits without allowing for any change in the rates on

bank toans.1° The rise in the deposit rate is found to bring forth a

rise in real GNP of about 0.3 billion won initially and 5 billion won

after 5 years. Real domestic investment is stimulated by the induced

private capital inflows which adjust the supply of money to the demand

for money. The wage rate is increased by an increased demand for labor

in response to the rise in the deposit rate and the subsequent rise in

the capital stock. The increased wage rate together with the capacity utilization rate raises price levels. Given the nominal value of governmen® expenditures, the increase in prices (including the GNP deflator) reduces real government spending and, thereby, lowers the increases in real GNP. Obviously, the rise in domestic prices and the rise in real GNP produce

a deficit in the balance of real net exports of goods and services. The

rise in export price induced by the rise in domestic prices and the real

trade deficit cause a deficit in the nominal balance of 8 billion won on™ the average over a 5 year period. In addition, the net capital inflow

is quite substantial, amounting to 10 billion won on the average. Thus,

the capital inflow which more than compensates the deficit in the balance

‘of goods and services leads to an increase in net foreign assets held by

the banking system.

a ata aia ated aliens beta aaa SU tind hon bien Sassou brn andl aials Ye, Leitner adn ands Lhe he Dh nd hae aien nent tached ence iad ee a ed oe “ee

an ee een a leet tte nen ee ee eee

tern ane cenen tattle tetas

= oi neat neni tnnteenamiaenthitnee tanned

iF soiteieea ah halen cade taate tele 5 died, te eli bidet tate tad lalate din taninn malin ints cine aehachns nena otcinamatn adie nadiniede dai dakinenniaamaeadinatiedinetentine be ietiienetnneramenneta aed: tek teehee ete

Fe Oe ee re a ee em ae at oe a one arte eh

Fe cat at all saat

ad .o ‘ . ~24- . - :

Investment and loans of the banking system to the domestic private

. - sector are considered in this paper as a monetary instrument. Lending

to the private sector is a domestic source component of the money supply, as stated in equation (20), and an increase in this monetary policy | instrument is similar to a reduction in the market lending rate in a developed economy, by increasing the supply of loanable funds. As re-

vealed in the table, the change in the monetary policy instrument is not

effective in bringing about changes in income and price levels. /4 tt is accompanied by a reduction in the capital inflow and a balance of payments deficit of about 3 billion won. That is to say, the availability of investible funds-~bank loans and foreign capital borrowings remains un-

affected by a change in the domestic source. This result, however, rests

on the implicit assumption underlying investment equation (2) that pri-

vate borrowing from the domestic banking system is a perfect substitute

for borrowing from abroad and on the absence of sterilization operations

by the monetary authority. If these assumptions were replaced by more

realistic assumptions--that the two sources of funds have differential effects on domestic investment because of differential risks, and a

partial sterilization operation is undertaken to stabilize the movement

of the money supply——the rise in the domestic base would have been par- Lo.

tially offset by the reduction in the capital inflow.) In this case,

the monetary policy instrument will produce changes in domestic income

and price levels. Consequently, the conclusion that the monetary policy — ‘

is an ineffective instrument should not -:be accepted without the foregoing

explicit qualifications.

Tore one ep pezen

So RRR no OO RT I PIR

-25~

‘Table 4 presents the simulation results regarding changes in U.S. real GNP. The rise of $70 billion in U.S. real CNP roughly brings forth a rise of $8.5 billion in ageregate foreign income, as is clear from equation (23). This rise, of course, leads to a rise in the real exports in excess of real imports, thereby resulting in a substantial rise in real GNP of about 16 billion won, The accompanying increase in real demand calls for increases in price levels. The rise in price levels

is about 0.8 percent, on the everage. The increase in real income and

' price levels causes a rise in the demand for nominal money. This in-

creased demand for money can be satisfied with an increase in the foreign source of the money supply which induces a surplus in the balance of payments, as shown in the table. In this sense, a balance of payments problem can be said to be a monetary problem. It does not necessarily follow from this that an excess demand for money is the only condition that matters, unless all the goods as well as assets are homogeneous enough for the law of one price for one good to prevail in the world} Finally, simulation experiments are carried out to determine the effects on income, price levels, and the balance of payments of a hypo-~ ‘thetical devaluation of the Korean won by 10 percent in 1966. The results, presented in Table 4, show that domestic prices increase as the result of the currency depreciation.“ For instance, wholesale price levels are higher by about 5 percent than would have been expected in the absence of this policy change. The currency depreciation initially |

decreases the nominal balance of goods and services trade by 6 billion

won mainly because of the inelastic demand for imports in the short-run.

. re Po pean ee eer rm eee pata fe honteacacharmubenth eeicaadalindicaie nidhaimd, amd caeh cantina seinicediasata ined nn tat adetiniaticke te aa te a tee aa i“ ~~ ure tee “ . el

A RE AS RY RN NE ETI ENERO IA EO FR HIMES ea LS aa Cnn HR RE pm nee LO om angie . . ona ; os

Time Path of the Effects of an Increase in

’ a Oo Table 4 | I | U.S. Real GNP and the Exchange Rate oe ‘

KP -__GNP/PGNP_ EX -IM EX-IM . _. ANFA

ee

70 billion increase in U.S. real GNP (OXNP 5)

lst yr. 4.653 0.769 9.585 8.220 8.056 0.164 7.189

2nd yr. 7.565 1.051 15.715 11.135 9.037 2.098 ~ | 10.811 3rd yr. 7.458 0.971 17.083 11.965 8.495 3.470 12.321 4th yr. 5.971 0.819 16.832 12.784. 9.480 3.304. --- 12.932

Sth yr. 5.009 0.768 17.720 15.296 12.636 2.660 © 15.227

10% devaluation of Korean Won (AEKQO)

Ist yr. 0.981 3.374 3.882 8.380 14.497 -6.117 4.516

2nd yr. 4.731 4.086 11.987 19.754 20.659 -0.906 ° 15.303 3rd yr. 9.322 4.816 22.362 34.559 30.520 4.039 —- 27.553 4th yr. 12.765 5.380 32.392 © 53.457. 42.717 10.740 41.989

Sth yr. 17.535 5.759 42.472 79.279 60.142 19.136 59.131

U.S. real GNP and the exchange gate were individually shocked and dynamic simulations were run from 1966-1970. P is wholesale price index in | percent of the price index before the shock occurred; GNP/PGNP is real GNP; EX | ' is export-value of goods and services; IM is import value of goods and services; and ANFA is change in net foreign assets; K is capital stock (all in billions of Won). :

alt ath rhea Thai ass Pa a ad in dda Di Leteat asd natal ante t hd tana eae teaeienmnt enter iahintieeanieiadedindaaendneiemenemndadeiadonbeamematanendenaniniar ae naakamaaamnen nae aaa

-27-

This initial adverse effect terminates within 3 years from such an exchange rate change. Hence, the time path of the devaluation effect on

_ goods and services trade exhibits the J-curve behavior that has recently found favor in attempts to understand the effects of the depreciation

of the U.S. dollar in 1971. From the first year, however, the real balance of goods and services trade turns a surplus, thereby bringing about a rise in real GNP. Moreover, the positive effect on real income tends to increase as the real trade balance tends to improve over time. Also, the balance of payments has a surplus of 30 billion won on average, as a result of the currency depreciation. The important conclusion from this result is that a currency depreciation can be effective, as long

as relative prices after the devaluation differ from relative prices before the devaluation (partially due to the existence of non-tradeable goods sector). This proposition holds regardless of whether domestic

and foreign assets are perfect substitutes.

III. Conclusions

This paper attempts to provide an empirical framework for the analysis of output, inflation, and balance of payments behavior in a small open economy. The model presented in the paper is designed to meet this expository purpose. _ Thus, much remains to be improved in the sectoral specifications. Nevertheless, the results emerging from the simulations seem to add an interesting perspective regarding foreign influences on economic activity and inflation of a small open economy and the effectiveness of its fiscal, monetary, and exchange rate policies in altering

its domestic activity and inflation.

-

RELY PSI ETRE NE TOR RON TEI TN ER ET ERE TE IE LE EE ELUTE TP IGE CL CTRL IIT NT PONTE BERRY I ONLI TO AEE FE OEM

ORIOL Ora" ones = We NEE REE RY YP Ds ote

ewe pm te pay ag eon eee eg oma cig ote

- rate differentials are seen to promote the transformation of domestic

are lesser substitutes of foreign assets.

PET eR gE Reo NOTE SRE RR ORES RT RIN ON EE YT anne tet Aimy Re A rt enet wet ore My aay oe . a

ies meet renga meme APRA eM SOR Re A eA Rin ERR EERIE pon my mene me Rea eet le ome nA Ro eee

‘Fiscal policies are found ‘to affect significantly income, price

levels, and the balance of payments. Monetary policies affecting interest

savings. into domestic capital formation, thereby affecting domestic output and price levels. On the other hand, monetary policies to increase

the domestic source of the money supply seem to have a limited influence

», On economic conditions. As discussed, the effectiveness of money supply . policies depends crucially on the degree of the substitutibility between -funds borrowed internally and externally. A given change in the domestic

_ base of ‘the money supply may become more effective when domestic assets

a Changes in the exchange rate and foreign activity and price levels

_,have substantial influence on domestic activity and price levels. Taking

account of these foreign influences when formulating national policies

would facilitate achievement of the policy targets of a small open economy. This interdependence suggests further investigation of a broader issue,

namely, how and in what ways, a small economy can be insulated at minimum

- cost from undesirable disturbances originating abroad, . 5

ce ae an whe eects tania etal tet atts a2 cotnee ae ona eo ene ee

~29-

FOOTNOTES

4

* rhe author is an economist, Division of International Finance, Board of Governors of the Federal Reserve System. I want to thank Howard Howe for incisive comments and acknowledge helpful discussion of the issues dealt with in this paper with R, Berner, P. Clark, R. Emery, L. Girton, Dale Henderson and Guy Stevens. The conclusions of this paper are solely those of the author and do not necessarily reflect the views of the Board of Governors of the Federal Reserve System. This paper will be published in the Proceedings of the Pacific-Basin Central Bank Conference on Econometric Modeling, May 27-29, 1975, Federal Reserve Bank of San Francisco.

Isee Turnovsky and Kaspera [25], Henderson [13], and Dornbusch [9] for examples of recent studies, and Otani [23] for an example of an

empirical study.

This assumption itself needs to be tested, and an empirical test is . now in progress,

3the sectoral specifications are similar to the theoretical specifi-

cations of Turnovsky and Kaspera [25], with some modifications.

4uLS. price elasticity estimates of U.S. imports of manufactured goods are around 2.5. See Houthakker and Magee [14] and Kwack [18]. The income and price elasticity estimates of exports by the Bank of Korea [4] are 3.4 and 0.7, and the income and price elasticity estimates of imports are 1.7 and 0.7, respectively, >this finding is in agreement with the argument of Emery [10] that the rise in time and savings deposits since the Korean interest rate reform of September 1965 has not been accomplished by a relative decline in the demand deposits. He also argues that the interest rate policy in less developed countries aims at mobilizing more domestic savings to finance a higher rate of capital formation.

A more realistic wage equation is the specification generating very sticky wage response to changes in prices and capital stock in the short-run and increasing responses as time goes on.

See Kwack [20] for a list of references of this type of analysis.

8, am indebted to Dale Henderson for showing a proof of the proposition in a two country world and want to acknowledge that Appendix I may be regarded as a summary of his framework.

rhe magnitudes of the shocks (a), (c), and (d) are about 10% of the values for 1966, , .

eres epee — : : re Sa

ne ROT Or

~30-

.

10, rise in the deposit rate without changes in loan rates puts the financial burden on commercial banks. Implicitly, the Bank of Korea is assumed to take measures for reducing the financial burden, for example, lowering rediscount rates.

I sce Mundell [22] for a theoretical discussion.

1a or empirical evidence of this, see Herring and Marston [12]. oy 13the reason for this is that, if the small-country assumption for capital and goods markets is introduced, the money market condition is the only factor. For monetarist views, see Borts and Hanson [6], Girton and Roper [11], Johnson [16], and Komiya [17]. For a comprehensive comparison between the monetarist and conventional views, see Branson [7] and Henderson [13], who conclude that the monetarist view is a special case,

Mr wack [20] presents the evidence in the case of 11 developed

- countries.

Salas ea tatiana RR ee earn ee ee ce cae ”

annua y bestest areas shay or tends bile L bier ln Lib ee eee ee tittneadt Motil: Lik oo ened Ona Th alee cet tne eet, SOI she 2 Eh al etenl he 8 A eB hy Mn Sat AD ne Ra aK TOI, Bla tu te Pehl ORG REPRE DS EUE NRE RES ACRE ES ara WB i, 6 EOL bale Vs SY,

~31-

APPENDIX I

Equivalence of Monetary Approach of Balance of Payments to Conventional Approach in General Equilibrium Framework

Assume that 4 economic agents ~ private, government, bank, and foreign residents and 6 goods and assets - consumption goods, capital good, government bonds, foreign bonds, bank money, and international re-

serves. The following consolidated sheet can be set:

Units/ , Consump- Capital: Gov't For- ~~ Bank Int'l Interest Taxes types tion Goods Bonds eign Money Reserves | Income Goods - Bonds . . Private C-Q, 1-9, 6B OF oe 0 Geyer’) Gov't G 0 -AB - OO 0 . 0 iB ~-T Bank 0 o ~~ ap? 0 ~AM AR is? ip> Foreign 8% ik AB* . —AF* AMS . —AR* -(iB*-i*F*) 0 Prices Po ‘PY . q - Eqs 1 ot : q,Eq* —s_ iq ‘where: Cc = private demand for consumption goods Q& = private out put of consumption goods “I = private gross investment demand Q = private output of capital goods, : pes private holdings of domestic bonds

i .

private hondings of foreign bonds P = private holdings of money

6 = depreciation rate

. Pe OE IT Ne TNS PTY I TF ETT hale aah 2 eeicitiags NORE REET Y Lid POAT FROM TEL PEIN OL ETE YT ME CT PO PG ET TRL ET TORT MOT ST IT OT OTN NTT

+.

Tm ene pany a 2 prey oe pagpienernie . Sink dh a Did be ceed etait oe ane tana oes, Baneeen tal Lane aah anlar edn amen neta ine aioaienon aaa eC ee

M = R= * = Q%

[x = Be =

FR

RX = q = qe = E = Let us

are zero, Aq

~32-

domestic bond rate

foreign bond rate

private tax payments, net of subsidies government spending

government supply of bonds

tax receipts, net of subsidies

central bank's holdings of domestic bonds

money supply

central bank's reserve holdings

foreign supply of consumption goods to home country foreign demand for capital goods to home country foreign holdings of domestic bonds

foreign supply of bonds to home country

foreign reserve holdings

domestic bond price (related to i)

foreign bond price (related to i*)

exchange rate (No. of home currency per foreign)

assume that the capital gains due to changes in hand prices

= 0 and Aq* = 0, and that F* is denominated in foreign

currency. The budget constraints for agents are derived from the con-

solidated sheet:

(1) Private sector

PCHP I-SPK+AM +qQB KAP 1EqAF +q4T” AE, | =:

P PP a P ‘ = + ixEq*F -T - PQ tP Q +igs +i Eq*F T dP K+KOP +q*F AE

er mema etme ge ge . . mma PERE ~ 4 . ’ 4

co seen anna s seen Seamer eetnnaelneeeeenanetiishtes Beene Ae dit betaie tncminee

moves sie

-33-

(2) Government sector

PG = T+qAB-iqB, where T = TP +igp?

(3) Bank sector

‘AM = gABP+AR (assuming tax payment to government = igqB?)

(4) Foreign sector

PLIR-P Q&+isEq*PA-iqgh*+ qQhB*+AM*~Eq*AFA~q* FX AE = AR*.

Assuming the asset market is initially in stock equilibrium, the equilibrium for each of goods, bonds, and money markets must satisfy the following:

k4P_ Tx G-P Qa+P 1%

(5) PQoHPSQ, = P CHP I4P a

Cc (6) ABP +AB°4-AB* =AB

(7) AF’ = ars (8) OM + AM* = AM

(9) AR* = AR Equation (4) for changes in the international reserves can be re-

written using (5) and (9),

= - - {i*Ea*F -iaB* (10) AR {P.Q.+P,Q, (P CHP, I+PG) } 4+ {i EP iqB*}

et Ary. P 1 .P

+ {qAB*+AM*-Eq*F -q*F AE}

This equation is an absorption framework for analyzing payments. More-

over, the combination of (2), (3), (6)-(8) and (10), equation (10) becomes

(11) AR = ae + AM*-qABe.

we e a lalate aha bel atten ahaa hi oh sik nl bn ends cies cia kanel aemeea aie heen nadie red ome ee Te . : + - en my em TY . ig

oat ae en a nN neni Riana

a rerteenntnieene ee aoe meee .

~34-

Equation (11) is the basis of a monetary approach to the balance of

payments. As shown above, as long as ‘the specification maintains that

the sum of excess demand in the economy is zero, Equation (11) is de- 4 rived from equation (4) which represents the basis of a conventional:

approach, Therefore, two approaches are equivalent to each other. By

the same token, capital flows (as well as international payments account)

specified on the basis of the demand ‘for foreign bonds are equivalent

to those specified on the basis of the excess demand for money in a general

equilibrium framework.

Raine eit tias eabatetine naena anata ard ae ST On Een Rn Np RN UR eR E ey tee en ee kee oy a a ers mam neeaprreprens

(2] [3]

+ A cRNA = ne ae tn ene ym oy ad bal

[4]

[5]

[7]

[8]

[9]

p-dAAtA OA ncaneenttinste Alans itt nw sam em ere Sar AT nein et en oon orer that Peet te temana teen

(20) [11] ¢

[12]

| |

(1).

[6]

[13]

14]

~35- _ REFERENCES

Bank of Japan, Economic Statistics Monthly (Tokyo, Japan).

Bank of Korea, “Monthly Economic Statistics (Seoul, Korea).

Bank of Korea, "Short-Run Model of Korean Economy (BOKM-ITT) ,". Monthly Research Review, 28 (July, 1974), pp. 4-26.

Bank of Korea, "Income and Price Elasticity Estimates of Korean Exports and Imports," Monthly Research Review, 27 (September, 1973), pp. 39-46.

Board of Governors of the Federal Reserve System, Federal Reserve . Bulletin (Washington, D.C.). .

Borts, George H, and J.A. Hanson, The Monetary Approach to the Balance of Payments, unpublished, (1975.

Branson, William H., “Nlonetarist and Keynesian Models of the Trans~-

. Mission of Inflation," American Economic Review, Papers and Proceedings, 87 (May, 1975), pp. 115~119.

- Chen, Chau-Nan, "Economic Growth, Portfolio Balance, and the Balance

of Payments," Canadian Journal of Economics, 8 (February, 1975), pp. 24-33.

Dornbusch, Rudiger, ''Currency Depreciation, Hoarding, and Relative Prices," Journal of Political Economy, 81 (July/August, 1973), pp- 893-915. .

Emery, Robert F., The Use of Interest Rate Policies as a Stimulus to Economic Growth, Staff Economic Studies, 5 (Summer, 1971), “Board of Governcrs of the Federal Reserve System, Washington, D.C.

Girton, Lance and Don Roper, A Monetary Model of Fixed and Flexible

. Exchange Rates Applied to the Post-War Canadian Experience, unpublished, Narch, 1975, _

Heres: Richard J. and R.C. Marston, The Monetary Sector in an

en Economy: An Empirical Analysis for Canada and Germany, a eeublished. December, 1973.

on

Henderson, ‘Dale W.,; Monetary, Fiscal, and Exchange Rate Policy in

.a Two Country, Short-Run Macroeconomic Model, unpublished, December, 1974. we er

Houthakker, H.S. and S.P. Magee, “Income and Price Elasticities in World Trade," Review of Economics and Statistics, V (May, 1969), pp. 11-125,

NOUN NE FREON FRI OE 8 ONE AO eT OPO: EO A YT AR IR ROE OR fe NO ER A RE eS Hn Rt ER Sp ee mM i

ay ana

[15]

[16] [17] [18]

(19).

-~36-

International Monetary Fund, International Financial Statistics (Washington, D.C.). .

Johnson, Harry G., "The Monetary Approach to Balance of Payments Theory," in Further Essays in Monetar Economics (Cambridge: Harvard University Press, 1973), PP. 229-249, oS

Komiya, Ryutaro, "Economic Growth and the Balance of Payments: A Monetary Approach," Journal of Political Economy, 77 (January / February, 1969), pp. 35-48, .

Kwack, Sung Y., "The Determination of U.S, Imports and Exports: A Disaggregated Quarterly Model, 1960III-19671v," Southern Economic eoutnern &conomic Journal, 38 (January, 1972), pp. 302-314,

Kwack, Sung Y. and G.R. Schink, "A Disaggregated Quarterly Model of U.S. Trade and Capital Flows: Simulations and Tests of

2. Policy Effectiveness," in Gary Fromm and L. Klein (eds.), The

[21]

[22]

Brookings Model: Perspective and Recent Development (North- Dao eee ECTI a eve topment Holland Publishing Co., 1974), forthcoming.

Kwack, Sung Y., Price Linkage in an Interdependent World Economy: Price Responses to Exchange Rate and Activity Changes, International Finance Discussion Paper #56, January, 1975, Board of Governors of the Federal Reserve System. Presented at NBER Conference on Research in Income and Wealth--"Price Behavior: 1965-1974," held on November 21-23, 1974, forthcoming.

McKinnon, Ronald I., Money and Capital in Economic Development.

" “ (Washington, D.C.: The Brookings Institution, 1973),

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