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The author wishes to thank Eswar Prasad, William Lee, Tarhan Feyzioğlu, Dora Iakova, Hong Liang, Jorge Chan-Lau, and staff of the Hong Kong Monetary Authority for discussions and for providing comments on an earlier version of this paper.
July 2003 figures indicate that deflation is continuing: prices fell by 4.0 percent, year-on-year, although this sharp decline is partly attributable to temporary utility rate concessions granted by the government.
There are three main reasons why stock prices have been used in lieu of property prices. First, the former ensures consistency with the predictions of economic theories that suggest the existence of a stable long-run arbitrage relationship between output and real stock prices (see, for example, Blanchard, 1981). Second, it provides a means for capturing, in a broad sense, the effects of changes in asset prices on both the corporate sector’s balance sheets and households’ wealth. Third, stock prices are highly correlated with property prices—the correlation between stock prices and property prices over 1980: Q4-2002: Q3 is 0.85, suggesting that this approach might not be too restrictive in any case.
Note that, even the transitory shocks could, through their effects on private sector balance sheets, have persistent effects on prices that last beyond the duration of the shocks themselves.
The term “changes in the money supply” refers to increases (decreases) in the money supply beyond (below) what is required to finance long-run real GDP. It is also worth noting that real shocks could also include those changes in the supply of goods and services that are due to wealth/balance-sheets effects resulting from, for example, shifts in investors’ sentiment.
These restrictions were tested jointly since the Johansen maximum likelihood estimation procedure indicated the existence of three cointegrating relationships. The purchasing power parity restriction, when tested separately, was not rejected at the 5 percent significance level. See Becker (1999), Cassola and Morana (2002) for examples of studies using similar restrictions.
The permanent component of the rate of change in prices has been obtained from the estimates of the permanent component of the price level displayed in Figure 2.
Because these transitory real-asset price shocks do not create changes in households’ wealth and/or corporate balance sheets that lead to permanent changes in output, they could reflect swings in investors’ sentiment that affect the stock market without affecting the bond market significantly. Such shocks would leave market interest rates unchanged.
Although the magnitudes and duration of the transitory effects of these shocks are determined empirically, their zero long-run impact on the price level are imposed by the identification scheme.
Although the half-life of deviations from purchasing power parity appears not to be independent of the nature of the shocks that created it, estimates suggest a relatively fast speed of adjustment of the real exchange rate. It takes about eight quarters for half the effects of a cost-push shock to disappear, while half the effects of an aggregate-demand shock disappear only after 12 quarters.
Under the linked exchange rate regime, changes in the U.S. federal funds rate lead to comparable changes in Hong Kong SAR’s interest rate (Hong Kong interbank offered rate, or HIBOR). These changes imply adjustments in the monetary base to avoid capital flows that could put pressures on the exchange rate. The relative tightness of the monetary stance in the U.S. for Hong Kong SAR’s economy can be inferred from the fact that the stock of broad money stood at or below its permanent level—that is, the level of broad money that is required to finance long-run real output—over the 1996: Q1–2002: Q3 (Figure 12 third panel).
We used HK$ broad money as a measure of the stock of money in the economy. The use of broad money in the system is to account for the existence of a long-run stable money demand relationship and provide a monetarist explanation to deflation—that is, deflation, like inflation, is in the long run a monetary phenomenon. The stock of money supply is determined by the flows of funds in the different sectors of the economy and the stance of monetary policy in the U.S.