People’s Republic of China—Hong Kong Special Administrative Region: Selected Issues

This Selected Issues paper examines the fiscal outlook and policy options for the Hong Kong Special Administrative Region. The paper provides indicative estimates of how revenue and expenditure might evolve in the next five years under two fiscal consolidation scenarios with a different mix of revenue/expenditure measures to bring the fiscal position to balance by FY2006. The paper examines different revenue raising measures in light of the findings by the Advisory Committee on new Broad-Based Taxes. It also offers some thoughts on areas where potential expenditure savings could be made.

Abstract

This Selected Issues paper examines the fiscal outlook and policy options for the Hong Kong Special Administrative Region. The paper provides indicative estimates of how revenue and expenditure might evolve in the next five years under two fiscal consolidation scenarios with a different mix of revenue/expenditure measures to bring the fiscal position to balance by FY2006. The paper examines different revenue raising measures in light of the findings by the Advisory Committee on new Broad-Based Taxes. It also offers some thoughts on areas where potential expenditure savings could be made.

III. Deflation in Hong Kong SAR1

A. Overview

1. Hong Kong SAR has experienced continued deflation since the last quarter of 1998. The composite CPI fell by almost 14 percent from the third quarter of 1998 until December 2002; about half of this is accounted for by the decline in housing costs, following the bursting of the bubble in property prices in the mid 1990s.2 Other items that have also contributed significantly to the decline in prices include food, clothing and footwear, and durable goods (Table III.1). Falling prices have contributed to increased real debt burdens, depressed consumer confidence, tightened monetary conditions, and could have helped feed the contraction in aggregate demand (Table III.2).

Table III.1.

Contributors to Deflation

article image
Sources: CEIC database;and staff calculations.

Based on log-difference approximation.

Sum of the components using fix weights over the period September 1998 to December 2002.

Table III.2.

Economic Indicators

article image
Sources: CEIC Database;Authorities;and staff calculations.

Best lending rate minus actual yoy CPI inflation.

Interbank offered rate minus actual yoy CPI inflation.

level of unemployment rate prevailing in 1997Q3 and 2002Q4

2. Previous research suggested that, although structural factors have played a role, deflation was mainly attributable to cyclical factors. Staff analysis carried out during the 2002 Article IV Consultation showed that fluctuations in unemployment, nominal credit and the nominal effective exchange rate, which were considered as cyclical variables, were the main determinants of the decline in prices (IMF Country Report, No 02/99, Chapter III). This result implies that, as these cyclical factors turn around, deflation would end. Research by the HKMA arrived at similar conclusions (HKMA Research Memoranda, November 2001).

3. However, the persistence of deflation for such an extended period of time suggests that other factors may be at play. In general, an economy’s cyclical condition, as measured for instance by the output gap, can be affected by both transitory and permanent shocks, the relative importance of which determines the persistence of deflation. For example, as deflation increases the real debt burden, and becomes entrenched in expectations, private investment and consumption growth could decline, causing an even greater decline in economic activity.

4. This paper presents a more comprehensive analysis, which provides a decomposition of the aggregate price level into transitory and permanent components, and identifies the nature and origin of the shocks that drive these two components. The analysis is based on a methodology that has several features that are useful for analyzing deflation and its persistence. First, it provides a clear distinction between those driving forces of deflation that create trend movements in the variables (summarized in the permanent component) and those that generate temporary deviations from long-run equilibrium conditions (summarized in the transitory component). Second, it provides means for identifying the nature of those forces. The approach that is undertaken in this paper is a “structural” one as opposed to the commonly used “reduced form” approach. It helps, for example, to determine whether falling prices results from increased productivity, scarce money supply and/or temporary excess capacity. This is particularly relevant because the likely duration of deflation, its costs, and the policy actions that may need to be taken for combating it all depend upon the nature of its underlying causes.

5. Empirical evidence suggests that the contribution of the permanent component has become relatively more important over time in explaining deflation. The sustained fall in the aggregate price level is mostly accounted for by continuous declines in its permanent component which summarizes the cumulative effects of productivity shocks, scarce money supply, and price convergence with trading partners. These findings remain consistent with the staffs previous analysis since they indicate that, although the transitory component did contribute significantly to the initial phase of deflation, its effects are becoming progressively weaker.

6. The remainder of the chapter is organized as follows. Section B presents the model that has been used for analyzing deflation. It explains how the price level is decomposed into transitory and permanent components which reflect the effects of shocks that have an economic interpretation. These shocks are identified by imposing restrictions that are derived from economic theory. Section C presents the results. Section D provides an interpretation of the results. Section E concludes the paper.

B. The Framework

7. A structural vector error correction modeling approach à la King, Plosser, Stock and Watson (1991) is used to assess the nature and impact of shocks on prices to shed light on the main factors that are behind their sustained decline. The structural vector error correction model, also known as the common trends model (CTM), is well suited for analyzing the interaction between variables that display trends and are determined simultaneously, uses general restrictions derived from economic theory to identify the main driving forces behind the trends observed in aggregate macroeconomic variables, and ensures consistency between the short-run and long-run dynamics of those variables.3

8. The CTM includes the following variables: real output, measured as nominal GDP deflated by the (composite) consumer price index; broad money; the consumer price index; real asset prices, measured by the Hang Seng stock index deflated by the consumer price index; foreign prices in Hong Kong dollars (HKD), measured as the trading partners consumer price index expressed in HKD.4

9. Box III.1 provides a diagrammatic representation of this framework. It shows how the outturn the price level can be decomposed into two components that reflect its short-run and trend movements, and what are their main driving forces.

  • The first panel displays several possible factors which could, at each point in time, influence different sides of the economy (e.g., supply vs. demand, nominal vs. real, etc.).

  • The occurrence of an event related to these factors constitutes a “shock.” The nature of the shocks is determined according to which side of the economy they first have an impact on as well as the temporal nature of the shock (second panel). There are two types of shocks: transitory shocks that generate only short-run movements in the variables; and permanent shocks that generate both short-run and trend movements in the variables.5. The transitory shocks are: cost push shocks (e.g., changes in markup margins), aggregate demand shocks (e.g., temporary shift in consumers’ preferences), and liquidity preference shocks. The permanent shocks are: real (e.g., productivity) shocks, and changes in the money supply.6

  • Each of these shocks generates particular movements in the variables of the system that distinguish it from the others, (third panel). For example, the so-called “real” shock, which is related to factors such as productivity changes or labor market reforms, generates short-run (e.g., deviation from long-run equilibrium conditions) and trend movements in all variables, whether the latter are of a real or a nominal nature. The “nominal” shock generates short-run movements in all the variables and trends in only those variables that are of a nominal nature. The cost-push shock generate short-run movements in all variables, but do not affect their trends.

  • The distinction between these two types of shocks constitutes the pillar of the decomposition of each variable into a transitory component and a permanent component (fourth panel). For each variable, the combination of the short-run movements generated by both types of shocks constitutes its transitory component; while that of the effects of the permanent shocks on its trend or long-run dynamics constitutes its permanent component.

10. The identification of the shocks that drive these two components is based on restrictions that are derived from economic theory. They include restrictions that stem from the long-run equilibrium relationships of a stable money demand, purchasing power parity, and arbitrage between output and real stock prices.7 The money demand equation embeds the monetarist view that, in the long run, inflation/deflation is a monetary phenomenon. Purchasing power parity captures the effects of price convergence with trading partners. The arbitrage relationship between output and real stock prices captures the idea that certain developments in the real (supply) side of the economy, such as improved productivity or labor market reforms, can engender trends in asset prices because of their impact on current and prospective levels of corporate profitability. Additional restrictions that include the concept of long-run neutrality of money (vertical Phillips Curve) and assumptions on stickiness in the adjustment process of certain variables to shocks are also used to obtain an exact identification of all shocks in the system.

11. The interpretation of the permanent and transitory components of each variable depends upon the effects of which shocks they include. For example, because the transitory component of output includes the short-run effects of productivity shocks, it can not be literally considered as a standard measure of output gap that would convey the notion of pressures arising only from the demand side of the economy.

C. Results

12. Over the 1998Q4-2002Q3 period, the decline in the price level has been associated with a decline in both its transitory and permanent components.8 However, although downward pressures on the price level resulting from the decline in the transitory component have been very pronounced during the initial phase of deflation, they have become progressively weaker. Consequently, most of the fall in the price level between 2001Q3 and 2002Q3 is accounted for by the decline in its permanent component (Figure III.1).

Figure III.1.
Figure III.1.

Prices: Actual and Permanent & Transitory Components

Citation: IMF Staff Country Reports 2003, 142; 10.5089/9781451816846.002.A003

13. The sustained fall in prices results mostly from the effects of permanent shocks that determine entirely the path of the permanent component of prices, and have a substantial impact on the transitory component. The effects of transitory shocks on the transitory component of prices have been outweighed by those of permanent shocks over the deflation period (Figure III.2).9 Shocks such as productivity shocks, changes in money supply, and price equalization with trading partners have had a significant negative impact on the transitory component of prices over the 1998Q4-2002Q3 period.

Figure III.2.
Figure III.2.

Transitory Component of Prices: Contributions of Transitory Shocks

Citation: IMF Staff Country Reports 2003, 142; 10.5089/9781451816846.002.A003

14. In terms of the rate of change in prices (i.e. inflation or deflation), the estimates of the permanent component of prices show continued deflation due to permanent shocks such as productivity shocks, changes in money supply, and price equalization with trading partners over the last two years, (Figure III.3, permanent component).10

Figure III.3.
Figure III.3.

Year-on-Year Inflation rate: Actual and Permanent & Transitory Components

(in percent)

Citation: IMF Staff Country Reports 2003, 142; 10.5089/9781451816846.002.A003

Source: Staff estimates.

15. One approach to understanding the relative importance of different shocks is to examine their relative contributions to the variability of prices and output (Table III.3).

Table III.3.

Forecast Error Variance Decomposition

article image
S=short-term (l quarter)M=medium-term (12 quarters)L=long-term (40 quarters)

Prices

  • Permanent shocks contribute to 44 percent of the fluctuations in prices over the short-term (one quarter) and 94 percent over the long term (40 quarters). The relative contribution of each of these shocks is as follows.

    • Productivity shocks and shocks related to changes in the aggregate money supply and price equalization with trading partners account for 34 percent and 60 percent of the long-term fluctuations in prices, respectively.

    • However in the short and medium-term (12 quarters), productivity shocks are the main sources of variability in prices, accounting for 40 percent and 44 percent, respectively.

  • The contributions of transitory shocks represent about 56 percent of fluctuations in prices in the short-term, and decline to about 35 percent in the medium-term. They can be decomposed as follows.

    • Cost push shocks, that could reflect temporary changes in firms’ mark-up margins or rates concessions and waiver of water and sewage charges granted by the government, contribute the most to the variability of prices. They explain about 55 percent of fluctuations in prices in the short-term, and about 13 percent in the medium-term.

    • Aggregate demand shocks, such as discretionary fiscal policies or temporary changes in consumers’ confidence, do not have an immediate effect on prices, but explain about 16 percent of their fluctuations in the medium-term.

    • The effects of liquidity preference shocks on the aggregate level of prices are limited. Liquidity preference shocks explain only about 6 percent of the fluctuations in prices in the medium-term.11

Results (not reported here) of the historical decomposition of the price level into the components attributable to different shocks tell a similar story. Movements in the price level are largely determined by productivity shocks and shocks to the money supply and price equalization with trading partners.

Output

  • Permanent shocks contribute to 55 percent of output fluctuations in the short-term and about 93 percent in the long-term, the details of which are as follows:

    • Productivity shocks, changes in the aggregate money supply and price equalization with trading partners explain 88 percent and 5 percent of output fluctuations in the long-term, respectively. These shocks still account for an important part of its fluctuations in the short-term, accounting for 44 percent and 9 percent, respectively.

  • The contributions of the transitory shocks represent 48 percent of output fluctuations in the short-term, and decline to about 22 percent over the medium-term. The respective contribution of each transitory shock is as follows:

    • Cost push shocks account for 8 percent of the variability of output over the medium-term.

    • Aggregate demand shocks explain about 48 percent of the short-term variability of output. However, their relative contribution declines rapidly to about 11 percent over the medium-term.

    • Liquidity preference shocks explain about 3 percent of the variability of output over the medium-term.

16. Another approach to understanding the relative importance of shocks is to analyze their dynamic effects on prices. Such an analysis has several uses. First, it provides a means to verify the consistency of the effects of shocks with standard predictions of economic theory and, therefore, an assessment of the validity of the identification restrictions used. Second, it provides information about how shocks are propagated and amplified throughout the economy. Looking at the dynamic effects on prices of one-time shocks of different types (Figure III.4), results suggest the following.

Figure III.4:
Figure III.4:

Movements in the Price Level in Response to Different One-Time Shocks

Citation: IMF Staff Country Reports 2003, 142; 10.5089/9781451816846.002.A003

Soureces: Staff estimates.
  • The responses of prices to shocks are consistent with the predictions of standard economic theory. From an aggregate supply/aggregate demand perspective, a temporary real shock (e.g., one time increase due to higher productivity) that, say, corresponds to an outward shift of the long-run aggregate supply curve leads to a permanent decrease in prices (and increase in output). A temporary negative aggregate demand shock (of a Keynesian style), leads to an inward shift of the aggregate demand curve that induces a fall in prices in the short-run. With downward stickiness in wages, real wages increase leading to a decline in output and higher unemployment. In the long-run, as the aggregate supply curve flattens, prices go back to their initial level.12

  • The adjustment of prices to transitory shocks is gradual, which suggests some degree of stickiness. The maximum effect is reached after seven quarters in response to an aggregate demand shock, four quarters in response to a cost push shock, and eight quarters after a liquidity preference shock.13

D. Interpreting the Results

17. The high relative contribution of permanent shocks (productivity, money supply/price convergence shocks) to fluctuations in prices, compared to temporary shocks such as aggregate demand and cost push shocks, probably reflects the increased degree of integration between Hong Kong SAR and the Mainland of China and changes in the money supply.14 This implies that downward pressures could continue in the foreseeable future as (i) price differentials between Hong Kong SAR and the Mainland cities such as Shenzhen and Guangdong remain substantial and (ii) the stance of monetary policy in the United States could tighten when the economy recovers. Moreover, given that wage differentials between Hong Kong SAR and neighboring Mainland China cities have not narrowed substantially, the convergence process is very likely to continue in the near future.

18. The limited contribution and duration of the impact of aggregate demand shocks on prices, such as temporary fiscal measures, is consistent with evidence on the narrow tax structure and limited size of the fiscal multiplier in Hong Kong SAR. However, this result implies that macroeconomic policy actions oriented towards managing the demand side of the economy, in this case expansionary fiscal policies, may be unlikely to have a significant direct effect on price developments.

E. Conclusion

19. The analysis in this paper has shown that the effects of permanent shocks such as productivity shocks and shocks related to changes in the money supply and price convergence with trading partners have become more important over time in explaining deflation in Hong Kong SAR. These shocks originate partly from the real side of the economy (e.g., productivity), and partly from the monetary side, including the dynamic adjustment of prices for purchasing power parity purposes. In addition, the effects of temporary shifts in aggregate demand have been perpetuated by negative wealth and balance sheet effects in the corporate and household sectors arising from asset price declines over the past five years. The analysis has also shown that there is a prevalence of productivity and nominal shocks such as changes in the money supply and price convergence with trading partners in explaining price and output fluctuations.

Annex: Common Trends Representation

This appendix provides technical details about the methodology that has been used for analyzing the persistence of deflation. The first section provides a brief overview of the structural vector error correction model (common trends model). The second section presents the results of the estimation of the model.

A. Methodology

The common trends model aims at analyzing the interaction between the following five variables: output, noted yt, broad money, noted mt; the CPI, noted pt; trading partners’ CPI in Hong Kong dollar (nominal effective exchange rate times foreign prices), noted ep*t; and a measure of real stock prices (stock price deflated by CPI), noted ft1 All variables are expressed in natural logarithm. These five variables are grouped into a vector xt and decomposed into two components: a transitory component and a permanent component.

Representation

Formally, for this analysis, the common trends model (including exogenous variables) admits, after transformation, the following structural vector moving average representation.

tx=0x+t+Φ(L)Ψt+BΣi=1tZt+r(l)Ztwherext=[ytftmtptept*],(1)
τt=[βtθt],[βtθt]=[β0θ0]+[βt-1θt-1]+[βtθt],(2)
ωt=Fψt=F[ψtpermψttrans],
ψtperm=[ϑtςt],ψttrans=[εtadεtpricesεtIf]

τt is a vector of common stochastic trends. It includes a real stochastic trend, θt, and a nominal stochastic trend, βt, which are driven by ϑt, and ςt the structural (uncorrelated) real and nominal disturbances, respectively, ψt, is the vector of all structural disturbances, and Φ(L) is a polynomial matrix, with L the lag operator, zt, is a vector of exogenous variables, and Γ(L) is a polynomial matrix, εtad, εtprices and εtIf are disturbances (uncorrelated with the other disturbances), identified as an aggregate demand shock, a cost push shock, and a liquidity preference shock (the identification restrictions are discussed later).

Shocks

There are two types of disturbances: those that have permanent and transitory effects on each variable of the system, called permanent shocks, and those that have only transitory effects, called transitory shocks. The former type of shocks, ψtperm, is constituted of the real and nominal shocks, while the latter is constituted of the aggregate demand shock, the cost push shock, and the liquidity preference shock. The number of shocks of each type is determined by the number of variables in the system and the number of cointegration (i.e. long-run equilibrium) relationships that exist between them.

Transitory and Permanent Components

The transitory component of xt represents the temporary dynamic effects of all random disturbances of the system and exogenous variables, xttrans=Φ(L)ψt+Γ(L)zt The permanent component is the sum of the stochastic trends and the cumulative effects of the exogenous variables, xtp=Aτt+BΣi=1tzi. There are two common stochastic trends, of which generating processes are assumed to be random walk with drift.

The estimation and analysis of the CTM involves (i) the determination of the degree of integration of the series, (ii) the determination of the number and estimation of the cointegration relationships, (iii) imposing economic theory-based restrictions to identify the structural shocks, (iv) performing an impulse response analysis, and (v) variance decomposition analysis. The CTM has been estimated over the sample period 1980Q4-2002Q3. All data are from the CEIC database.

B. Results

Unit Root Tests and Cointegration Analysis

The standard Augmented Dickey-Fuller test could not reject the presence of a unit root in all variables. Tests of cointegration have been carried out using the Johansen (1988) maximum likelihood procedure. As shown in Table III.4, results indicate the existence of 3 cointegration relationships. However, for the 3 (normalized) cointegrating vectors to have any economic interpretation, one needs to impose restrictions that are provided by economic theory.

Table III.4.

Cointegration Test

article image
Notes: In bold indicates the rejection of the null hypothesis.

Because the study aims at analyzing deflation in a highly open economy with well developed financial markets, theories such the Quantity Theory of Money (QTM), Purchasing Power Parity (PPP), and Arbitrage Relationship between output and real stock prices provide restrictions that are useful for understanding the long-run determinants of the variables of the system, especially the price level. The QTM implies a cointegrating vector that includes output, money and the price level (and a measure of opportunity cost of holding money), with an income elasticity that has to be estimated and opposite unitary coefficients on money and the price level. The PPP implies a cointegrating vector which includes the domestic and foreign price levels, with associated coefficients equal to one and minus one, respectively. Although the cointegrating vector implied by the arbitrage relationship does not assign a specific value to the coefficient associated to output and real stock prices, it does suggest a positive relationship between them.

As shown in Table III.5, the null hypothesis of binding theoretical restrictions can not be rejected at any standard level, and the estimated coefficients are consistent with the predictions of the theories mentioned above.

Table III.5.

Test of Theoretical Cointegrating Vectors

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Note: Standard errors in parenthesis.
Identification of Shocks

The model is identified using the restrictions implied by the long-run equilibrium relationships, and long-run and short run restrictions à la Blanchard-Quah. The existence of 3 cointegration relationships implies that the system of five variables has two common stochastic trends that are driven by two structural shocks, which have a permanent effect on these variables.

The two permanent shocks are considered as a real (productivity/supply) and a nominal (change in average money supply/price convergence). The permanent real shock could possibly include productivity shocks, tax reforms, changes in labor market conditions, and more generally measures/events that affect the supply side of the economy. The permanent nominal shock could include all shocks that lead to (unanticipated) changes in the money stock relative to what is required to finance long-run real output, changes in the trend in inflation expectations, and permanent changes due to price convergence. In order to separately identify these two permanent shocks, one restriction needs to be imposed. The long-run neutrality of money, which implies that the permanent nominal shock does not affect real GDP has been imposed. This is sufficient to ensure a zero-effect of the permanent nominal shock on all real variables in the long-run.

The remaining 3 stochastic processes of the 5-variable system are driven by transitory shocks, of which identification requires the imposition of two restrictions. The restrictions on the effects of the transitory shocks on the short-run dynamics of the variables exploit information about lags in the propagation mechanism, sources of rigidities (e.g., contracts length), and other stylized facts. The following two restrictions have been imposed: (i) cost push shocks do not have an immediate impact on output, and (ii) liquidity preference shocks do not have an immediate impact on output and domestic prices.

Although these restrictions can not be tested since the model is exactly identified, their accuracy can be assessed through the analysis of the impulse response functions.

Impulse Response Analysis

Figures III.5-III.9 present the responses of the variables to the five shocks. Overall, all responses corroborate the predictions of standard economic theory, which provide support to the identifying restrictions that have been imposed.

Figure III.5.
Figure III.5.

Responses to Productivity Shock

Citation: IMF Staff Country Reports 2003, 142; 10.5089/9781451816846.002.A003

Source: Staff estimates.

A productivity shock leads to a permanent increase in output, real stock prices, money supply, and a permanent decline of the price level. Note that the responses of money and the price level imply a permanent increase in real cash balances. A nominal shock (permanent change in the money supply/price convergence) has transitory but persistent effects on real variables and permanent effects on all nominal variables. Output increases temporarily above its permanent level (after a temporary fall for two quarters). Real stock prices rise for about eight quarters and then fall following an increase in the price level and decline in broad money. The positive effects of the liquidity preference shock on output are short-lived and reversed after six quarters. This shock leads to a temporary gradual increase in the price level and a decline in broad money. A cost push shock reduces temporarily output, real stock prices and broad money. After an aggregate demand shock, output and the price level increase, while real stock prices and broad money decline.

Permanent and transitory components

20. Figures III.10III.11 present the actual levels of the variables of the system and estimates of their permanent and transitory components. The estimates help for example to identify periods during which deflation has been accompanied with increased productivity (permanent component of output), insufficient amount of money chasing real goods and services (transitory component of broad money), or negative swings in investors’ sentiment.

Figure III.6.
Figure III.6.

Responses to Permanent Nominal Shock

Citation: IMF Staff Country Reports 2003, 142; 10.5089/9781451816846.002.A003

Source: Staff estimates.
Figure III.7.
Figure III.7.

Responses to Liquidity Preference Shock

Citation: IMF Staff Country Reports 2003, 142; 10.5089/9781451816846.002.A003

Source: Staff estimates.
Figure III.8.
Figure III.8.

Responses to Cost Push Shock

Citation: IMF Staff Country Reports 2003, 142; 10.5089/9781451816846.002.A003

Source: Staff estimates.
Figure III.9.
Figure III.9.

Responses to Aggregate Demand Shock

Citation: IMF Staff Country Reports 2003, 142; 10.5089/9781451816846.002.A003

Source: Staff estimates.
Figure III.10.
Figure III.10.

Permanent and Transitory Components of Prices

Citation: IMF Staff Country Reports 2003, 142; 10.5089/9781451816846.002.A003

Source: Staff estimates.
Figure III.11.
Figure III.11.

Permanent and Transitory Components of Other Variables

Citation: IMF Staff Country Reports 2003, 142; 10.5089/9781451816846.002.A003

Source: Staff estimates.

References

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  • Blanchard, Olivier-Jean, 1981, “Output, The Stock Market, and Interest RatesAmerican Economic Review, Vol. 71, pp 132143.

  • Blanchard, Olivier-Jean, and Danny. Quah, 1989, “The Dynamic Effects of Aggregate Demand and Supply Disturbances,” American Economic Review, Vol. 79, pp. 655673.

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1

Prepared by Papa N’Diaye.

2

March 2003 figures indicate that deflation is still continuing as prices fell by 2.1 percent year on year.

3

Technical details are presented in the Annex.

4

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 (e.g., 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 the 1980Q4–2002Q3 period is 0.85, suggesting that this might not be too restrictive in any case.

5

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.

6

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.

7

These restrictions were tested jointly since the Johansen Maximum Likelihood estimation procedure indicated the existence of 3 cointegrating relationships. The PPP restriction, when tested separately, was not rejected at the 5 percent level. See Becker (1999) and Cassola and Morana (2002) for examples of studies using similar restrictions.

8

The shocks that drive these two components are orthogonal by construction. But there is no restriction that the temporary and permanent components themselves be uncorrelated.

9

The transitory component represents the temporary dynamic effects of all random disturbances and exogenous variables on the variables of the system.

10

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 III.1.

11

Because these transitory real asset prices shocks do not create changes in households’ wealth and/or corporate balance sheets which 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.

12

While 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.

13

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 those of an aggregate demand shock disappear only after 12 quarters.

14

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 (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 United States 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, i.e., the level of broad money that is required to finance long-run real output, over the period 1996Q1-2002Q3 (Figure III.7, third panel).

1

We used Hong Kong dollars 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.

People’s Republic of China—Hong Kong Special Administrative Region: Selected Issues
Author: International Monetary Fund