This Background Paper provides a broad overview of the structure and characteristics of public finances in Korea, and discusses fiscal policy against the background of the medium-term objectives. The analysis shows that despite constraints imposed by the institutional framework, the government has managed to maintain tight budgetary control. The paper analyzes trends in the size and composition of central government expenditure, revenue, financing, and debt. It also evaluates the stance of fiscal policy on the basis of summary indicators.

Abstract

This Background Paper provides a broad overview of the structure and characteristics of public finances in Korea, and discusses fiscal policy against the background of the medium-term objectives. The analysis shows that despite constraints imposed by the institutional framework, the government has managed to maintain tight budgetary control. The paper analyzes trends in the size and composition of central government expenditure, revenue, financing, and debt. It also evaluates the stance of fiscal policy on the basis of summary indicators.

VI. The Inflation Process in Korea 1/

1. Introduction

A notable feature of the present expansion in Korea is the subdued behavior of inflation. Recent price developments bear some similarities with developments in the expansion of 1986-88, and contrast markedly with the more rapid acceleration of inflation in the 1990-91 expansion. Given broadly similar rates of monetary growth 2/ and a similar degree of overall resource pressures as measured by the estimated output gaps, the question arises why price behavior has differed in these expansions. One factor accounting for the differences appears to be the structure of the expansions. While the expansion of 1990-91 was mainly concentrated in the nontraded goods sectors such as construction and services, the present expansion, as that of 1986-88, has been led by strong growth in the manufacturing sector, stimulated by buoyant exports. 3/ Another important factor appears to be differences in wage behavior.

This chapter analyzes the inflation process in Korea since the early 1980s. The analysis focusses on the behavior of wages and prices in the traded and nontraded goods sectors and takes the factors that affect the level and the composition of demand, including monetary policy, as given. Section 2 briefly describes the main features of recent expansions: their structure and developments in wages and prices. Section 3 develops a simple model for the analysis of the wage-price mechanism in a small open economy. Section 4 discusses some stylized facts of the process of wage and price determination in Korea. Section 5 presents estimation results for wage and price equations for the traded and nontraded goods sectors, and section 6 summarizes the main conclusions of the chapter.

2. Wage and price behavior in recent expansions

Since the mid-1980s Korea has experienced three economic expansions: in 1986-88, in 1990-91, and, most recently, since late 1993. These three expansions have been broadly similar in term of the estimated overall output gaps (Table VI.1) and average rates of money growth. M2 averaged 18.1 percent in 1986-88, 19.8 percent in 1990-91, and 16.5 percent in 1994 and the first half of 1995. Average consumer price inflation, however, was more than twice as high in 1990-91 (9 percent) as in 1986-88 (4.3 percent), and was 5.5 percent in 1994 and the first half of 1995. The expansions have also differed in a number of other important aspects: the composition of demand, the sectoral contributions to growth, and the behavior of wages. 1/

Table VI.1.

Korea: Growth, Wages, and Prices, 1985-95

(Percent change per annum, unless otherwise indicated)

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Sources: Bank of Korea, National Accounts, Monthly Statistical Bulletin; and staff estimates.

Percent change over same quarter in the previous year, unless otherwise indicated.

GDP excluding value added in agriculture, forestry and fisheries, as well as government sector.

Construction, utilities and services.

Calculated as (1 - actual output/potential output) * 100 for the nonfarm private sector. Potential output was estimated by smoothing the log of actual output, using a Hodrick-Prescott filter.

Seasonally adjusted figure.

Difference between the actual unemployment rate and the trend unemployment rate, with the latter approximating the natural rate. The trend employment rate was estimated by smoothing the series on the actual unemployment rate, using a Hodrick-Prescott filter.

Average hourly compensation.

Excluding agriculture, forestry and fisheries, but including the government sector. Separate employment data are not available for the latter. Not adjusted for cyclical variations.

Construction, utilities, and private and government services.

Both, the boom of 1986-88 and the most recent expansion, were led by rapid export growth, reflecting strong demand in partner countries as well as gains in competitiveness (Chart VI.1). 2/ Buoyant investment activity in 1986-88, and even more so in the present expansion, reflected largely strong equipment investment, with construction growing at a more moderate pace. In both expansions, private consumption lagged behind the growth of overall economic activity. However, the composition of demand changed in the course of the 1986-88 expansion with construction investment and consumption picking up, and there are indications that a similar shift is now under way.

CHART VI.1
CHART VI.1

KOREA: DEMAND, OUTPUT, COST AND PRICES, 1985–95

(Percent change over same period in the previous year)

Citation: IMF Staff Country Reports 1995, 136; 10.5089/9781451822014.002.A006

Source: Bank of Korea, Monthly Statistical Bulletin and National Accounts; and staff estimates.1/ 1990 prices.2/ Private non-farm sector.3/ Excluding agricultural products.

In contrast to these expansions, the boom of 1990-91 was driven by domestic demand. Construction investment accelerated sharply, stimulated by expansionary financial policies, which sought to offset the faltering of exports following a sharp appreciation of the real effective exchange rate in 1988-89. Private consumption was boosted by large income gains due to a sharp acceleration of wage increases since 1988. The composition of demand shifted only in the latter part of the expansion, with construction and private consumption moderating and exports recovering.

The differences in the composition of demand in recent expansions were reflected in the sectoral composition of growth. In 1986-88, and also in the present expansion, activity in the manufacturing sector outpaced growth in the other sectors. In 1990-91, by contrast, economic activity was dominated by the construction and services sectors, with manufacturing lagging behind.

Even though the degree of resource pressure as measured by the estimated output and unemployment gaps 1/ was similar in the expansions of 1986-88 and 1990-91, price developments differed significantly. In 1986-88, consumer prices remained initially subdued but picked up by nearly 2 percentage points (excluding agricultural products) in the third year of the expansion. In the 1990-91 expansion, consumer price inflation rose as soon as growth strengthened after the sharp but brief downturn in 1989. Both, in 1988 and in 1990, the acceleration of inflation reflected mainly a sharp pickup in the non-manufacturing component of the consumer price index (services and housing-related items). 2/ Manufacturing prices remained subdued during the expansion of 1986-88, followed by a relatively moderate pickup in 1989-90.

The differences in the development of manufacturing and other prices suggest that the behavior of inflation in the past two expansions was influenced by the relative strength of specific demand components and differences in pricing behavior in the sectors where demand pressures were concentrated. In addition, wage developments differed significantly. In 1986-88, constraints on wage bargaining kept wage increases initially under control. This policy resulted in a significant buildup of profits, notably in the manufacturing sector. In response, wage increases accelerated sharply in 1988, facilitated by the liberalization of wage bargaining in the context of political liberalization. Wages continued to rise rapidly in 1989, notwithstanding the sharp downturn in economic activity, and moderated only gradually from 1991 onward.

3. The wage-price mechanism in a small open economy

The standard model of wage and price behavior, which combines a simple Phillips curve with a markup pricing equation, 1/ does not distinguish between traded and nontraded goods. This distinction plays a key role in the “Scandinavian model of inflation.” 3/ Based on a number of assumptions that describe essentially long-term equilibrium relationships between the key variables, the model suggests that in a small open economy the domestic rate of inflation is determined by the rate of change of international prices for traded goods, the nominal exchange rate, and productivity growth in the traded and nontraded goods sectors. Given its focus on long-run equilibrium and the supply side, the “Scandinavian model” is not a suitable framework for an analysis of wage and price developments in the short run. Its emphasis on the distinction between traded and nontraded goods provides, however, a useful starting point for & discussion of inflation in a small open economy.

The assumptions underlying the “Scandinavian model” are (with lower case letters indicating growth rates):

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Assumptions (1), (2) and (3) together imply that wages in the traded and nontraded goods sectors can grow at the rate of productivity growth in the traded goods sector plus the scope provided by changes in international prices of traded goods (adjusted for exchange rate changes).

The overall price index is defined as a weighted average of the price indices for traded and nontraded goods, with weights α and (1-α). Combining the above terms then yields

p  =α*(pw+e)+(1α)*(wnqn)(5)

which describes changes in the overall price index as a weighted average of changes in international prices of traded goods and the exchange rate, and unit labor cost in the nontraded goods sector. Simplifying (5) further to

p=(pw+e)+(1 - α)*(qt  -  qn)(5)

yields the price equation of the “Scandinavian model.” Equation (5’) implies the well known result that a country’s real exchange rate (defined in terms of the overall price index) will tend to appreciate (depreciate) relative to another country if the (positive) gap between productivity growth in the traded and nontraded goods sectors in this country is larger (smaller) than in the other country (Samuelson/Balassa effect). 1/

The main merit of the “Scandinavian model” is that it highlights the long-run structural determinants of inflation in a small open economy. Even though it focusses on the real side and does not explicitly incorporate monetary factors, it implicitly allows for monetary policy effects on inflation through the exchange rate. 2/ However, while the model provides a useful framework for the analysis of inflation in the long run, particularly if it is extended to incorporate monetary factors, it is not well suited for an analysis of wage and price developments in the short run. In the short run, factor income shares can vary, wages in the tradable and nontradable goods sectors may deviate, and demand conditions, in both goods and labor markets, matter. 3/ The remainder of this section thus focusses on the modifications of the wage and price equations that are needed to allow for demand effects in the short and medium run. The critical distinction between price behavior in the tradable and nontradable goods sectors is retained, and it is shown that the essential long-term results of the “Scandinavian model” continue to hold.

As a first step, it is convenient to retain the original price equations of the model and assume that wage determination is adequately described by a standard Phillips curve 1/

w=β0-β1*u+pe(6)

with pe indicating expected inflation, u the unemployment rate, and w=wt=wn. Equation (6) can be solved for the unemployment rate unat that is consistent with real wages in the traded and nontraded goods sectors growing at the same rate as labor productivity in each sector, implying constant factor income shares 2/

unat=(1/β1)*(β0-(α*qt+(1-α)*qn)(7)

Equation (7) does not differ from the standard formulation for a closed economy, 3/ except that labor productivity growth is expressed as a weighted average of productivity growth in the traded and nontraded goods sectors. Using (7) to incorporate unat explicitly in the Phillips curve equation yields

w=-β1*(U-Unat)+pe+(α*qt+(1-α)*qn)(6)

In the short run, wage developments are affected by labor market conditions, but in the long run, with U = Unat, and pe = p, assumptions (2) and (4) of the “Scandinavian model” hold.

While long-run equilibrium requires equalization of wages in the traded and nontraded goods sectors, 4/ labor market rigidities may cause temporary deviations. For example, if due to labor market conditions, errors in price expectations, or temporary disturbances wage developments deviate from their long-term equilibrium path, profit margins and factor income shares in the traded goods sector change since prices are constrained by developments in international prices and the exchange rate. 5/ Eventually, such changes would be corrected through their impact on labor demand in the traded goods sector. It is possible, however, that employers and employees take changes in income shares into account in the process of wage bargaining so that

w=-β1*(U-Unat)+pe+(α*qt+(1-α)*qn)-β2*Z(6)

with Z indicating past deviations from the long-term income share of labor. Since in equilibrium Z=0, equation (6’’) retains the long-run properties of the original model, but includes an adjustment mechanism that limits deviations from long-run income shares, which otherwise would only be corrected through their impact on employment. 1/ Evidently, such a bargaining strategy is only feasible if there are rigidities in the labor market that permit temporary deviations in wage developments in the traded and nontraded goods sector. Labor market and wage developments in Korea suggest that such rigidities exist and that they are taken into account in the decentralized wage bargaining process (see next section).

The price equations of the “Scandinavian model” assume complete price taking behavior in the traded goods sector. While this may be a reasonable approximation to describe the pricing behavior of Korean exporters in foreign markets, 2/ it appears too rigid an assumption for the traded goods sector as a whole. Given the structure of Korean imports, which suggests relatively limited import competition, 3/ and the possibility of price discrimination between foreign and domestic markets by Korean exporters, 4/ the prices of tradable goods that are sold domestically may only depend to a limited degree on changes in foreign prices and the exchange rate, and to a significant degree on domestic cost and demand factors, the latter being approximated by the output gap (Y - Yp)

ptd=δ1*(pw+e)+δ2*(Y-Yp)+(wt-qt)(8)

Similarly, equation (4) can be modified to allow for a variable markup

pn=γ1*(Y-Yp)+(wn-qn)(4).

The price index for all traded goods is a weighted average of ptd, the goods sold domestically, and ptw, the goods sold abroad 1/

pt=θ1*(pw+e)+θ2*(Y-Yp)+θ3*(wt-qt)(1)

with θ1θ4 depending on the relative weights of ptd and ptw as well as the coefficients of equation (8).

Equation (1’) is sufficiently general to accommodate less than complete price taking behavior on the part of exporters. This would be reflected in a smaller coefficient of the foreign price and exchange rate variables and a larger coefficient of the cost variable, which does not have to be, however, equal to one. It is worth noting that as long as exporters are assumed to be complete price takers and domestic prices in the traded goods sector are independent of foreign prices (δ1=0), the proposition of the “Scandinavian model” concerning the equilibrium path of wages and the long-run determinants of overall inflation (5’) still hold. If these assumptions are replaced by a more general price equation as described by (1’), the influence of foreign prices (and the exchange rate) on overall inflation and the equilibrium path of wages in the long run depends on the coefficients of the price equation for the traded goods sector as a whole. 2/

Equations (6’’), (4’), and (1’) describe a simple framework for the analysis of wage and price developments in Korea. Given the differences in pricing behavior in the traded and nontraded goods sectors, the variable capturing demand pressures (Y - Yp) should reflect domestic rather than total demand. Moreover, the larger is the share of goods sold abroad and the more prevalent is price taking behavior in the tradables sector, the smaller will be the effect of demand and wage pressures on prices in this sector. 3/ Under these conditions, an expansion that is characterized by strong foreign demand and, at least initially, subdued domestic demand can indeed be expected to result in more moderate price pressures than an expansion led by domestic demand, particularly if labor intensity in the traded goods sector is lower than in the nontraded goods sector, and if there are short-term rigidities in the labor market that permit temporary deviations in wage developments in both sectors.

4. Wage and price determination in Korea: some stylized facts

The framework developed in the previous section combines the key elements of the “Scandinavian model,” (the distinction between traded and nontraded goods, and assumptions about differences in pricing behavior in the two sectors) with the standard Phillips curve approach. A key question is whether such a framework captures the main stylized facts of the process of wage and price determination in Korea.

Price developments in the traded and nontraded goods sectors since 1983 are summarized in Chart VI.2. They suggest that pricing behavior in both sectors differed indeed significantly. While the “nontraded goods” component of the consumer price index (services and housing cost) appears to have followed relatively closely cyclical developments, the “traded” goods component (manufacturing goods) appears to have been affected relatively little by domestic demand conditions. This does not, however, imply that domestic prices in the traded goods sector have mainly been influenced by foreign price developments as the “Scandinavian model” assumes. Developments in the manufacturing component of the consumer price index have, in fact, deviated considerably from developments in export prices. Although this may, to some extent, reflect differences in the coverage and weights of the two indices, it nevertheless suggests that price discrimination between foreign and domestic markets may play a role.

CHART VI.2
CHART VI.2

KOREA: PRICE DEVELOPMENTS, 1983–95

(Percent change over same period in the previous year)

Citation: IMF Staff Country Reports 1995, 136; 10.5089/9781451822014.002.A006

Source: Bank of Korea, Monthly Statistical Bulletin; and staff estimates.1/ Excluding agricultural products.2/ Including housing and utilities.3/ Weighted average of export unit values of competitor countries.

A notable feature of price developments in the traded goods sector is that Korean export prices in terms of U.S. dollars appear to have followed, albeit with a lag of several quarters, the export prices of major competitor countries. This observation is borne out by a regression of changes in the dollar prices of Korean exports on past changes in competitor prices. 1/ This could be interpreted as evidence that Korean exporters are indeed price takers in foreign markets and adjust their won prices in line with movements in foreign prices and the exchange rate. However, the close relationship between changes in dollar export prices and past changes in foreign prices may also reflect the response of exchange rate policy. A regression of changes in the won/dollar exchange rate on past changes in competitor prices suggests that this is indeed the case in Korea, 1/ and that changes in export prices in terms of won account for a relatively small part of the adjustment.

Wage and productivity developments in Korea since 1983 are summarized in Chart VI.3. They indicate that wages in the traded and the nontraded goods sectors have generally moved closely together, and that productivity growth has tended to be higher in the traded than in the nontraded goods sector, two key assumptions underlying the “Scandinavian model.” However, during 1987-90, wages in the traded goods sector outpaced wage increases in the nontraded goods sector by a significant margin, resulting in a marked upward shift in the previously (and subsequently) relatively stable relative wage between the two sectors (Chart VI.4). This shift occurred during the period of “wage explosion,” which appears to have been a response to the preceding redistribution of factor incomes in favor of profits, as indicated by the development in factor income shares. This redistribution, and the subsequent response, appears to have been considerably more pronounced in the traded goods sector than in the nontraded goods sector.

CHART VI.3
CHART VI.3

KOREA: WAGES AND PRODUCTIVITY, 1983–95

(Percent change over same period in the previous year)

Citation: IMF Staff Country Reports 1995, 136; 10.5089/9781451822014.002.A006

Source: Bank of Korea, Monthly Statistical Bulletin; Ministry of Labor, Yearbook of Labor Statistics; and staff estimates.1/ Excluding agriculture and government.2/ Four quarter moving average of year-on-year change in output per man hour.3/ Excluding agriculture.
CHART VI.4
CHART VI.4

KOREA: RELATIVE WAGES AND FACTOR INCOME SHARES, 1970–94

Citation: IMF Staff Country Reports 1995, 136; 10.5089/9781451822014.002.A006

Source: Bank of Korea, National Accounts, Ministry of Labor, Yearbook of Labor Statistics; and staff estimates.1/ Hourly earning in manufacturing relative to other sectors (excluding agriculture and government).

5. Econometric analysis of wage and price behavior

Based on the framework developed in section 3, wage and price equations were estimated for the traded and nontraded goods sectors. As in the preceding sections, the former is broadly identified with the manufacturing sector, while the latter comprises all other sectors, with the exception of agriculture and government.

The wage equations were specified so as to capture the special features of the Korean wage system. Total earnings consist of a basic wage, which accounts on average for some 70 percent of total monthly earnings and is determined in annual wage negotiations, generally at company level. In addition, employees receive overtime and special bonus payments. Although trade unions have increasingly sought to include bonus payments in annual wage contracts, they remain a relatively flexible element of the wage system, depending mainly current labor market conditions and productivity developments.

Given the two main components of total earnings, the wage equations reflect the factors that are expected to influence the annual wage negotiations, which determine the base wage for the following year, as well as factors that affect additional payments during the year. Current labor market conditions, reflected in the difference between the actual and the trend unemployment rate, Ugap, and current productivity growth q are expected to influence bonus payments, while labor market conditions, productivity developments, and inflation expectations pe at the time of the last wage round are expected to determine developments in the base wage. Efforts to correct past deviations in factor income shares, captured by the variable Z, are assumed to play a role mainly in annual wage negotiations, while sectoral differences in labor market conditions, approximated by the difference between employment growth in the manufacturing and non-manufacturing sectors, are expected to affect bonus payments. 1/

The estimation results for the wage equations are summarized in Table VI.2. The results suggest that the framework developed in section 3 fits the data quite well, both in the manufacturing and the other sectors. All coefficients, with the exception of the variable approximating price expectations, are significant and have the expected signs. As predicted by the model, the sum of the coefficients of the productivity variables is close to unity in most equations. The large coefficients of the unemployment variable, Ugap, can be attributed to the fact that due to cyclical variations in labor force participation, the unemployment rate in Korea varies relatively little over the cycle. Differences between the actual unemployment rate and the trend unemployment rate have typically ranged between 1/4 and 1/2 of one percentage point in recent years.

Table VI.2.

Korea: Wage Equations

article image
Source: Staff estimates.

Private nonfarm sector, excluding manufacturing.

Note: The dependent variables are the growth rates of average hourly earnings in the manufacturing sector (traded goods sector) and in all other sectors, excluding agriculture and government (nontraded goods sector). All growth rates are defined as the fourth difference of the log of the series multiplied by 100. The equations were estimates by OLS for the period 1984Q2 to 1994Q4. t values are shown in parentheses below the coefficients.

The explanatory variables are defined as follows: Ugap is the difference between the unemployment rate and an approximation of the natural rate, derived by applying a Hodrick-Prescott filter to the original series. Ugap(-4) is a four quarter moving average of Ugap lagged four periods, q is labor productivity growth in the respective sectors, defined as output per man hour. qtr(-4) is the trend growth of labor productivity lagged four quarters, derived by applying a Hodrick-Prescott filter to the original series. pe(-4) is a four quarter moving average of the rate of consumer price inflation, lagged four periods. Z is a four quarter moving average of the difference between the actual income share of capital and the trend share, derived by applying a Hodrick-Prescott filter to the original series. le is the difference between the growth rate of employment in the manufacturing sector and in all other sectors.

The estimation results indicate a few notable differences between the process of wage determination in the manufacturing sector and the other sectors. While overall labor market conditions appear to have a strong impact on both wage negotiations and bonus payments in the manufacturing sector, they seem to influence only the wage bargaining process in the other sectors (services, utilities, and construction). In these sectors, current wage payments appear to be affected by sectoral differences in labor market conditions, with faster growth in manufacturing employment relative to other sectors exerting a moderating influence.

The most important difference between wage behavior in the manufacturing sector and the other sectors concerns the role of shifts in factor income shares. Efforts to correct past deviations from trend income shares appear to have been an important factor in the wage bargaining process in the manufacturing sector, and, indeed, seem to explain much of the “wage explosion” in the late 1980s. However, following a sharp rise in the income share of labor in 1988-89, this feature of the wage process appears to have contributed to the steady moderation of wage increases in subsequent years, notwithstanding tight labor market conditions. In other sectors, the shift in factor income shares in the mid 1980s was much less pronounced, and, consequently, did not have a significant impact on wage developments.

Estimation results for the price equations are summarized in Table VI.3. Since quarterly data on value added deflators are not available, prices in the traded and nontraded goods sectors were approximated by the manufacturing and the services 1/ components of the consumer price index. 2/ A notable feature of the price equations is that the coefficients of the unit labor cost variables, while significant in all equations, are well below unity, suggesting that only a part of the cost increases were passed on to prices. While such pricing behavior would not be sustainable in the long run, it is the mirror image of the large shifts in factor income shares in the past ten years, which went far beyond the usual cyclical variations in income shares and are therefore not captured in the cyclical variables. 3/

Table VI.3.

Korea: Price Equations

article image
Source: Staff estimates.Note: The dependent variables are the rates of increase of the manufacturing and the services (including utilities and housing) components of the consumer price index. All growth rates are defined as the fourth difference of the log of the series multiplied by 100. The equations were estimated for the period 1983QI-1994QIV using the Cochrane-Orcutt procedure to correct for serial correlation in the residuals. The estimated first order autocorrelation coefficients of the residuals are indicated in the last row of the table. t values are indicated in parentheses below the coefficients.The explanatory variables are defined as follows: Ygap is the difference between actual and potential output in the private nonfarm sector (excluding manufacturing) in percent of potential output. Potential output was estimated by smoothing the log of actual output, using a Hodrick-Prescott filter. ΔYgap is the first difference of Ygap. (w - qtr) indicates an eight quarter moving average of changes in unit labor costs in the manufacturing and nonmanufacturing (excluding agriculture and government) sectors, respectively. Changes in unit labor costs are defined as the difference between the growth of average hourly earnings and the growth of output per man hour averaged over four quarters (trend productivity growth) in each sector, pm is a four quarter moving average of import price increases, (Pw + e) is a four quarter moving average of changes in competitor prices (in U.S. dollars) and the won/dollar exchange rate. Competitor prices are calculated as a weighted average of export unit values of major competitor countries using export-based weights.

The estimation results suggest that price behavior in the manufacturing sector (traded goods sector) differ from that in other sectors (nontraded goods sector) in several respects. Prices in the nontraded goods sector not only respond more strongly to increases in unit labor cost than domestic prices of manufacturing goods, they also react more strongly to domestic demand conditions, approximated by the output gap in the non-manufacturing sectors. 4/ While a positive output gap of one percentage point adds nearly as much to the non-manufacturing component of consumer price inflation, an increase in the positive output gap by the same amount would raise the manufacturing component by less than one 1/2 of one percentage point.

In contrast to the assumptions underlying the “Scandinavian model,” there is no evidence of a significant impact of foreign price developments on domestic manufacturing goods prices. Neither changes in foreign competitor prices nor import prices are significant in the price equations. While the latter reflects a relatively low degree of import penetration in the consumer goods sector, the former could be interpreted as evidence of price discrimination on the part of Korean manufacturers between foreign and domestic markets. However, clarification of this issue would require an analysis of the pricing behavior of Korean exporters, which is beyond the scope of this study.

6. Conclusions

Price developments in recent expansions in Korea have differed significantly. While resource pressures, as measured by overall output gaps, have been broadly similar, the expansions have differed in terms of their structure (the relative contributions to growth of the traded and nontraded goods sectors), and wage developments. In order to assess the importance of differences in the composition of demand as well as special factors influencing wage behavior, a simple theoretical framework for the analysis of wage and price behavior in a small open economy was developed. The framework combines key elements of the “Scandinavian model of inflation,” notably assumptions about differences in pricing behavior in the traded and nontraded goods sectors, with a standard Phillips curve approach.

Although the results of the econometric analysis of wage and price developments do not fully agree with the predictions of the model, they are consistent with the view that price, and to a lesser extent wage, behavior in the traded (manufacturing) and nontraded (other) goods sectors differ. In particular, the impact on prices of cost and demand pressures is much stronger in the nontraded goods sector than in the traded goods sector. Thus, even though in the late 1980s wage and unit labor cost increases in the manufacturing (traded goods) sector exceeded those in other sectors, increases in domestic prices of manufacturing goods were more moderate than price increases in other sectors. The resulting shift in factor income shares in favor of labor income was in large part a correction of the redistribution in favor of profits that had occurred in the preceding years.

Given the large shifts in relative income shares during the estimation period, caution seems warranted in drawing general conclusions from the estimated parameters of the price equations. Nevertheless, to the extent that they suggest a stronger response to cost and demand pressures in the nontraded than in the traded goods sector, they imply that, at least in the short run, the composition of demand matters for the behavior of inflation in an expansion. Ultimately every expansion, irrespective of its origin, will lead to price pressures as it affects labor market and domestic demand conditions. However, an expansion that is initially concentrated in the traded goods sector is likely to be associated with more moderate inflation than an expansion that is fuelled by demand for nontraded goods, particularly if production in the traded goods sector is less labor intensive than production in the nontraded goods sector. Thus measures of price pressures based on estimates of the overall output gap are likely to over- or underestimate the true underlying price pressures, depending on the structure of the expansion.

APPENDIX Data Sources

Bank of Korea, Monthly Statistical Bulletin, various issues: balance of payments, consumer prices, producer prices, export prices, and import prices; employment, unemployment, and labor force.

Bank of Korea, National Accounts, various issues: GDP in constant 1990 prices, sectoral value added, national disposable income and its appropriation.

IMF, International Financial Statistics, various issues: exchange rates, export unit values.

Ministry of Labor, Yearbook of Labor Statistics, various issues: total monthly compensation by sector, average hours worked per month.

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1/

Prepared by Marianne Schulze-Ghattas.

2/

While in the 1970s, rapid monetary growth fuelled by extensive policy-based lending played an important role in the inflation process, in the 1980s the focus of monetary policy shifted toward stabilization and monetary growth was brought down. As a result of this reorientation, inflation declined from an average of 16 percent in the 1970s to just over 5 percent during 1983-94. Since the mid 1980s, monetary policy has generally attempted to strike a balance between accommodation and restraint. Even though monetary control was complicated by large shifts in the balance of payments position, monetary policy generally succeeded in insulating domestic monetary conditions through extensive sterilization operations.

3/

While the degree of exposure to foreign competition varies among industries in the manufacturing sector, the sector as a whole can be identified with the traded goods sector.

1/

They also differed significantly in terms of the external positions. In particular, while the current account registered large surpluses in the expansion of 1986-88, both the expansion of 1990-91 and the most recent one have featured current account deficits.

2/

While gains in competitiveness in the mid 1980s were associated with a sharp depreciation of the won in real effective terms during 1985-86, the decline in the real effective exchange rate since the early 1990s has been relatively moderate. In both periods, however, the won depreciated significantly against the yen. The differences in the response of exports to changes in the real effective exchange rate may be due to changes in the geographical distribution of Korean exports, which are not captured in the weights of the real exchange rate index. They may also be due to changes in the commodity composition of exports, which imply shifts in the response to a given change in partner countries’ exchange rates.

1/

See footnotes to Table VI.1 for a brief description of how these gaps were estimated.

2/

The consumer price index (excluding agricultural products) is a good indicator of overall price developments in Korea; it has moved broadly in line with the GDP deflator (excluding agriculture). The producer price index has a large import component and is thus heavily influenced by movements in import prices.

3/

See, for example, Adams and Coe (1990).

1/

This model was originally developed in the 1960s by a group of Norwegian economists led by Odd Aukrust. The discussion in this section is mainly based on a restatement and extension of the model by Lindbeck (1979).

1/

Defining (5’) for two countries c1 and c2, assuming α1 = α2 = α, and subtracting the two equations yields

e21-(p2-p1)=(1-  α)*((q1t-q1n)-(q2t-q2n))

with e21 = e2 - e1 denoting the change in the bilateral nominal exchange rate between the two countries.

2/

While in a fixed exchange rate system, domestic inflation is fully determined by (5’) and monetary disequilibrium is reflected in the balance of payments, under flexible exchange rates monetary policy can influence domestic inflation. The “Scandinavian model” does not incorporate this aspect of the adjustment mechanism but it can be extended to include it. In fact, equation (5’) can be considered a modification of the standard PPP assumption underlying the monetary approach to the balance of payments.

3/

The neglect of the demand side in the “Scandinavian model” has been widely criticized whenever it was used to analyze wage and price developments in the short run (see, for example, the comments on the paper by Aukrust in Krause and Salant (1977)). The assumptions that are required to ensure that price developments are independent of demand factors within a simple general equilibrium framework are discussed in Kierzkowski (1976). De Gregorio et al. (1994), and Gordon (1994) propose alternative assumptions to obtain this result.

1/

The inclusion of a Phillips curve is, in fact, sufficient to introduce demand effects.

2/

Expected inflation is assumed to be equal to actual inflation and no distinction is made between consumer prices and product prices.

4/

Permanent deviations between wage developments in the traded and nontraded goods sectors would require fully and permanently segmented labor markets.

5/

By contrast, in the nontraded goods sector wage increases are passed on to prices and income shares remain unchanged.

1/

Equation (6’’) is, of course, similar to a standard error corrections formulation.

2/

Athukorala’s (1991) study on exchange rate pass-through suggests that Korean exporters are largely price takers and try to keep their prices in line with those of foreign competitors.

3/

Some 90 percent of Korean imports are intermediate and capital goods for which there are generally no close domestic substitutes. While imports of consumer goods have increased significantly, they still account for a relatively small share of imports.

4/

For a simple model of price discrimination in domestic and foreign markets see, for example, Aspe and Giavazzi (1982) and Ohno (1989). While models of price discrimination generally assume imperfect competition in all markets, the assumption of perfect competition in the foreign market and imperfect competition in the domestic market can be considered a special case of the more general model.

1/

The price indices are defined as value added deflators and therefore ignore the direct impact of import prices.

2/

The unemployment rate unat that is consistent with the equilibrium path of wages and, hence, constant factor income shares, is independent of the specification of the price equations as long as price expectations focus on overall inflation rather than domestic prices alone. If the latter dominate and domestic prices in the traded goods sector are influenced by foreign prices, unat will be a positive function of the rate of increase of foreign prices converted into national currency.

3/

The traded goods sector does, of course, respond to wage pressures, but changes in employment or a wage bargaining process that takes into account changes in factor income shares (as described by equation (6’’)) may play a more important role than price adjustments.

1/

A regression of annual percentage changes in Korean export prices in terms of U.S. dollars, px$, on a weighted average of export unit values of major competitor countries, pw$, yields (t-values are indicated in parentheses):

px$=0.21*p(2.73)w$+0.84*p(9.62)x$[-1]R2:0.92D.W.:2.11

1/

The regression results are (all variables in terms of year-on year changes; t-values in parentheses):

e=0.21*p(2.68)w$+0.87*e(9.64)[-1]R2:0.95D.W.:1.97

1/

See note to Table VI.2 for a detailed description of the variables.

1/

Including housing cost and utilities.

2/

While the producer price index covers mainly manufacturing goods, it has a large import content and is therefore not a good indicator of domestic prices.

3/

While the wage equations include a variable that captures this effect, the price equations do not, and the coefficients of other variables may reflect part of the effect.

4/

In order to capture sector-specific demand pressures, the output gap in the manufacturing sector was included in the price equations. However, domestic manufacturing prices appear to be related to domestic demand pressures for which the output gap in the non-manufacturing sectors seems to be a better proxy.

Korea: Background Papers
Author: International Monetary Fund
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    KOREA: DEMAND, OUTPUT, COST AND PRICES, 1985–95

    (Percent change over same period in the previous year)

  • View in gallery

    KOREA: PRICE DEVELOPMENTS, 1983–95

    (Percent change over same period in the previous year)

  • View in gallery

    KOREA: WAGES AND PRODUCTIVITY, 1983–95

    (Percent change over same period in the previous year)

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    KOREA: RELATIVE WAGES AND FACTOR INCOME SHARES, 1970–94