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.
Becker, Torbjorn, 1999, “Common Trends and Structural Change: A Dynamic Model for the pre- and Post-revolution Islamic Republic of Iran,” IMF Working Paper, WP/99/82 (Washington, D.C.: International Monetary Fund).
Blanchard, Olivier-Jean, and Danny. Quah, 1989, “The Dynamic Effects of Aggregate Demand and Supply Disturbances,” American Economic Review, Vol. 79, pp. 655–673.
Cassola, Nuno, and Claudio Morana, 2002, “Monetary Policy and the Stock Market in the Euro Area,” ECB Working Paper series, No. 119.
King, Robert, Charles Plosser, James Stock Mark Watson, 1991, “Stochastic Trends and Economic Fluctuation,” American Economic Review, Vol. 81, pp. 819–840.
Prepared by Papa N’Diaye.
March 2003 figures indicate that deflation is still continuing as prices fell by 2.1 percent year on year.
Technical details are presented in the Annex.
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.
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 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.
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.
The transitory component represents the temporary dynamic effects of all random disturbances and exogenous variables on the variables of the system.
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.
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.
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.
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.
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).
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.