There is a long-standing argument in the literature that in less developed countries (LDCs) the quantity theory framework is more applicable and relevant than are Keynesian effective demand theory models. A number of studies, with a varying degree of reliability, support this view. Among these, Harberger’s (1963) study on the Chilean inflation is the one most often quoted. The framework of analysis Harberger uses is a quantity theory model in which the rate of inflation is explained by the supply of money, real income, and the expected rate of inflation. In a recent study, Vogel (1974) extends Harberger’s analysis to other Latin American countries and also arrives at Harberger’s conclusion that inflation in these countries is largely a monetary phenomenon. While the Harberger and Vogel studies are interesting and throw some light on the process of inflation, they are not without defects.
One defect is the so-called reduced form approach, which might be subject to a simultaneous equation bias as well as misspecification errors.1 Also, the authors assume that the stock of money is an exogenous variable. This assumption may be invalid in LDCs with a relatively large foreign sector, fixed exchange rates, and an underdeveloped financial sector. A third defect is that real income is determined outside the system in Harberger’s model. That is, Harberger ignores the interaction between money and real income.
The main purpose of this paper is threefold: First, to remedy various aspects of the defects inherent in a single-equation approach to an explanation of a monetary phenomenon. For this purpose, the presently fashionable monetary approach to the balance of payments seems to be a useful starting point for correcting these defects. According to the monetary approach, the supply of money is treated as endogenous because of the feedback from the balance of payments through changes in the net foreign assets position to those in the monetary liabilities of the central bank. At the same time, income is regarded as being influenced by changes in the money supply. Second, to construct a simultaneous-equation system of a quarterly monetary model of the Korean economy and to test the validity of the model against the data for the period 1962-74. Third, to analyze influences on major macroeconomic variables—including real output, prices, and balance of payments—of alternative policy instruments, by way of simulation exercises.
Section I of this paper is devoted to the specification of a quarterly model, emphasizing the relation between the monetary sector, aggregate demand and supply, and the foreign sector, and to the examination of the estimated model. In Section II, a variety of simulation exercises is performed to examine the model’s properties, such as stability, predictive ability, symmetry, and multiplier analyses; policy implications are drawn. Section III presents concluding remarks.
APPENDIX: Data Sources and Derivations
Andersen, Leonall C., and Jerry L. Jordan, “Monetary and Fiscal Actions: A Test of Their Relative Importance in Economic Stabilization,” Federal Reserve Bank of St. Louis, Review, Vol. 50 (November 1968), pp. 11–23.
Edgerton, David L., “Some Properties of Two Stage Least Squares as Applied to Nonlinear Models,” International Economic Review, Vol. 13 (February 1972), pp. 26–32.
Fisher, G.R., and D.K. Sheppard, “Interrelationships Between Real and Monetary Variables: Some Evidence from Recent U.S. Empirical Studies,” in Issues in Monetary Economics: Proceedings of the 1972 Money Study Group Conference, ed. by H. G. Johnson and A. R. Nobay (Oxford University Press, 1974), pp. 179–259.
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)| false Fisher, G.R., and D.K. Sheppard, “Interrelationships Between Real and Monetary Variables: Some Evidence from Recent U.S. Empirical Studies,”in Issues in Monetary Economics: Proceedings of the 1972 Money Study Group Conference, ed.by ( H. G. Johnsonand A. R. Nobay Oxford University Press, 1974), pp. 179– 259.
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)| false Sowey, Eric R., “Stochastic Simulation of Macroeconometric Models: Methodology and Interpretation,”in Econometric Studies of Macro and Monetary Relations( Papers presented at the second Australasian Conference of Econometricians held at Monash University, August 9-13, 1971), ed.by ( Alan A. Powelland Ross A. Williams Amsterdam, 1973), pp. 195– 230.
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)| false Swoboda, Alexander K., “Monetary Policy Under Fixed Exchange Rates: Effectiveness, the Speed of Adjustment, and Proper Use,”in Issues in Monetary Economics: Proceedings of the 1972 Money Study Group Conference, ed.by ( H.G. Johnsonand A.R. Nobay Oxford University Press, 1974), pp. 52– 74.
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)| false Zellner, Arnold, and Stephen C. Peck, “Simulation Experiments with a Quarterly Macroeconometric Model of the U.S. Economy,”in Econometric Studies of Macro and Monetary Relations( Papers presented at the second Australasian Conference of Econometricians held at Monash University, August 9-13, 1971), ed.by ( Alan A. Powelland Ross A. Williams Amsterdam, 1973), pp. 150– 68.
Mr. Otani, economist in the Asian Department, is a graduate of the University of California at Berkeley and the University of Minnesota.
Mr. Park, a graduate of Seoul National University and the University of Minnesota, was an economist in the Financial Studies Division of the Fund’s Research Department when this paper was prepared. He now teaches at Korea University, Seoul, Korea.
An earlier version of the paper was presented at the winter meetings of the Econometric Society, held in Dallas, Texas, in December 1975.
The expression “reduced form approach,” which is often used in studies of monetary economics, is misleading, since it does not usually refer to the approach of estimating a behavioral equation in terms of all the exogenous variables that appear in the system of equations. Rather, it refers to the estimation of a single equation in terms of a subset of these exogenous variables. Our criticism refers to this kind of a single-equation approach.
This model may meet the challenge posed by Fisher and Sheppard (1974, pp. 236 and 223), who argued very convincingly that “the FRB-St.L. approach as typified in the work of Andersen and Jordan , is based on two econometric heresies: disregard for structure and the spurning of disaggregation” and that “large econometric models … typically … violate almost every tenet of econometric theory.” They also criticize large models for not being consistently formulated among different blocks of equations.
On a purely theoretical level, a2 is negative or positive depending upon the elasticity of the demand for real narrow money, and of the demand for real savings and time deposits, with respect to the interest rate (R). Therefore, the sign of a2 is an empirical question.
That is, the adjustment coefficient of the adaptive expectation hypothesis is unity. The validity of this assumption and empirical support can be found in Toyoda (1972), Silveira (1973), and Otani (1975), where the rate of inflation is calculated at an annual rate.
This assumption implies that the price elasticity of the foreign demand for the Korean exports is zero and that there are no close substitutes for them in the world market. Such assumptions may be a bit strong, but we reluctantly made these assumptions to avoid a considerable degree of complications in the model that may arise from alternative specification to allow the existence of close substitutes for the Korean exports in the world market.
Since the manufacturing sector of the Korean economy engages in the production of items that contain substantial amounts of imported raw materials and other intermediate goods, it is essential to treat these imports as a factor of production. See Bardhan (1970), ch. 4, for theoretical treatment of this issue.
N = (CT − CF)/W ⋅ (1 + γ/β)
IMi = (CT − CF)/PMi ⋅ (1 + β/γ)
Substitution of these values in the production function—that is, equation (11)—gives rise to
Solving this expression for CT in terms of Yms and the parameters, the total cost function is obtained. Differentiate CT with respect to Yms and set it equal to the price of output, P. The resultant expression becomes a supply function for Yms, which has the form
log Yms = f(log P, log W, log PMi, t)
where f1 > 0, f2 < 0, f3 < 0, and f4 > 0;
fi being the partial derivative with respect to the zth argument. Since the foregoing formulation gives rise to the problem of multicollinearity, the final expression contains real wages and import prices relative to the domestic prices as shown in equation (16).
See also Evans (1969), ch. 10. His arguments can be summarized as follows. A neoclassical type of supply function is not suitable for explaining the short-term fluctuations in output. This happens primarily because firms do not immediately adjust their short-run position to the one suggested by static microeconomic theory. Equation (17) can be obtained by modifying the production function—that is, equation (11)—in the following form:
Yms = A(K ⋅ CP)α ⋅ Nβ ⋅ (IMi)γ
It can be shown that the coefficient of log (CP)—that is, g4—is expected to be positive.
An empirical counterpart of this example is provided later.
Howrey and Kelejian (1969) argue that when a model contains analytical solutions concerning its properties, simulation exercises would not provide additional information, and that simulation exercises should be used only when analytical techniques are not available for obtaining solutions. But Naylor (1971, p. 299) argues that there may be many cases in which “an economist may conclude that the model may not have a known analytical solution. However, it may very well be that if the economist made a thorough search of the literature in mathematics or consulted with a mathematician, it might be possible to find an analytical solution to the model.” Naylor contends that such a search would not be worth the effort.
“To validate any kind of model (for example, economic models) means to prove the model to be true. But to prove that a model is ‘true’ implies (1) that we have established a set of criteria for differentiating between the models that are ‘true’ and the models that are ‘not true,’ and (2) that we have the ability to readily apply these criteria to any given model” (Naylor and Finger, 1971, pp. 153-54). “By validation … is understood simply determining whether the model fulfils well the demands made of it. It is not a question whether the model embodies strictly causal mechanisms, but rather whether the estimated model, with all its inherent imperfections, does an adequate job of prediction, both within and beyond the estimation period” (Sowey, 1973, pp. 195-96). These authors define “validation” quite differently; in fact, Naylor and Finger emphasize much stricter conditions than does Sowey. They argue that the model must have a high degree of “goodness of fit” and that the assumptions upon which it rests must be valid. This section considers the first point of their argument; Section I has already considered the second point.
Some of these controls were adjusted by the introduction of a proxy for the foreign exchange limitation or dummy variable for imports of intermediate goods, but they are evidently not sufficient to capture all the effects of controls.
That is, the direct linkage between NF and B; the indirect linkage between TM and NF(B); IMi and NF(B); IMc and NF(B); Y and Yms; C/TM and m.
Deviation from the output of the base run is measured in percentage terms.
We refrain from making any judgments concerning which policy in a global sense would be most effective, since effectiveness would vary according to the magnitude of the policy package, the range in which the magnitude can change, and the initial condition.
This is done by raising the actual values of import prices by 10 per cent for the period of simulation. In addition, the net foreign assets position of the central bank at the beginning of the simulation period is also increased by 10 per cent to reflect the increased value in terms of the local currency.
In the remainder of this section, an increase (+) or a decrease (−) refers to the position of the simulation results relative to the output of the “base run.”
The increase in the net foreign assets position results in an increase in the base money; however, because of a decline in the money multiplier, the stock of money decreases.
Some explanation for the negative elasticity of real income with respect to the exchange rate changes is in order. In this model, there is no automatic mechanism by which the depreciation of the currency affects the exports. The exports are determined by the demand condition of the rest of the world. Only to the extent that the depreciation induces changes in the general price level does it give rise to an increase in export receipts in local currency. Therefore, the effects of the depreciation on the economy are felt only through changes in imports and net foreign assets.
It can also be said that the Korean economy tends to be influenced even more by changes in import prices.
Elasticity of a variable with respect to the stock of money can be obtained by dividing the elasticities of the variable with respect to policy instruments by the elasticities of the stock of money with respect to the corresponding policy instruments.
There is no guarantee that the four policy instruments are sufficient to reach the four, or even three, policy targets in this nonlinear system. If we find that the policy goals are not achieved by these instruments for one reason or another (say, political constraint), additional policy instruments must be included. For example, wage rate and (net) foreign capital inflow would be good candidates for additional instruments in our model.
This index alone is not a good indicator over a long period of time, but it seems sufficient for the purpose of determining general fluctuations within one year.