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L RESER\!
Nel
. . . . . . MI~
......W
MONEY; INFLATION
AND TRADE
IN THE PACIFIC BASIN
SUMMER 1978
The Federal Reserve Bank of San Francisco’s Economic Review is published quarterly by the
Bank’s Research and Public Information Department under the supervision of Michael W. Keran,
Vice President. The publication is edited by William Burke, with the assistance of Karen Rusk
(editorial) and William Rosenthal (graphics).
For free copies of this and other Federal Reserve publications, write or phone the Public Informa
tion Section, Federal Reserve Bank of San Francisco, P.O. Box 7702. San Francisco, California
94120. Phone (415) 544-2184.
in the Pacific Basin
I.
Introduction and Summary
II.
Rational Expectations and Counter-Cyclical Monetary
Policy: The Japanese Experience
Charles Pigott
. . . Counter-cyclical policy apparently has been
used effectively in Japan, despite the “rational
expectations” argument that such a policy would
be ineffective.
III.
IV.
Inflation and Monetary Accommodation in the Pacific Basin
Michael Bazdarich
. .. Persistent inflation in eight Pacific countries has
reflected continuing increases in money supplies,
with the causality running from money growth to
inflation rather than the other way around.
Alternative Balance-of-Payments Adjustment Experiences:
Korea and Taiwan, 1973-77
Hang-Sheng Cheng
. . . Korea followed an adjustment policy of exchange-rate
devaluation, which added to its inflation rate, while
Taiwan followed a policy of reducing aggregate demand,
which reduced its inflation rate.
Editorial committee for this issue:
Kurt Dew, Larry Butler, Michael Gorham
4
6
23
37
Future historians will probably write bookshelves about the striking fact that most of the
economic success stories of the late 20th century
have occurred in the islands and peninsulas of
East Asia. Japan of course is the obvious example, but South Korea, Taiwan, Hong Kong, Singapore and Malaysia all can boast similar
successes. The causes of this phenomenon are
many and complex--eultural strengths, -market
disciplines and many other factors are surely involved. We do not attempt any broad answers
here, but we are able to throw some light on the
subject by investigating whether the traditional
tools of monetary and fiscal policy apply differently in these fast-growing Pacific Basin countries than in the United States. The three papers
in this issue apply new views on macro-economic
policy and new analytical techniques in an attempt to advance the discussion.
Charles Pigott examines Japan's experience
with counter-cyclical monetary policy, especially
in the context of the "rational expectations" argument that a policy of this type is likely to be
ineffective. As the theory goes, counter-cyclical
policy has no systematic effect on real variables
once private agents determine how the authorities conduct their policy. Once the policy is
known, the changes in the money supply it produces are predictable, so that they then cease to
influence real activity. But Pigott's results suggest, at least tentatively, that counter-cyclical
policy has been used effectively, in the sense that
it has not been frustrated by offsetting actions of
the private sector.
Over the 1957-77 period, Pigott finds, anticipated increases in Japanese money growth stimulated real economic activity-particularly
industrial production-while anticipated reductions in money growth depressed activity. But
these findings for Japan are nearly opposite to
those found in some recent studies of U.S. monetary policy. Taken together, these results imply
that in Japan, the predictable part of money
growth affects real output most heavily, while in
the U.S., only unanticipated money growth influences economic activity. Institutional factors
may account for some of these differences. In Japan, short-term capital markets are less developed-and close substitutes for money are thus
less available-than in the United States. Moreover, Japanese corporations are strongly dependent upon the private banking sector for external
funds, because of the relatively underdeveloped
nature of Japanese bond and equity markets.
Pigott adds that the contrasting results might
also reflect differences in U.S. and Japanese
monetary policies. In Japan, M 1 grew (on average) at a stable pace, whereas in the U.S., money
growth generally increased from the mid-1960's
through the early 1970's. "This suggests that an
unexpected acceleration of money growth in the
U.s. was often followed by further above-average increases, while in Japan, on the other hand,
money acceleration was generally followed within several quarters by deceleration. Consequently, an unanticipated money change in Japan,
once perceived by individuals, possibly could
have had a more temporary impact on real balances than would have been the case in the U.s.';
The success of the East Asian economies has
not encompassed price stability, according to
Michael Bazdarich. He notes that a pattern of
persistent inflation has occurred over the 195777 period in eight Pacific Basin countries-six
East Asian countries plus the United States and
Australia. Price levels have climbed steadily in
those countries, and at average rates that are
high by historical standards. "Furthermore,
there is no sign of a slowdown in this phenomenon. World inflation has not been a temporary
outbreak, confined to a few commodity prices,
but a continuing process affecting all prices."
In this analysis, Bazdarich argues that inflation can continue only if there are continuing in4
and Taiwan during the past several years. Both
countries sustained unusually large current-account deficits and borrowed heavily abroad following the 1973-74 oil shock, so that the world
banking community became concerned over
their mounting debts. Yet barely two years later,
both countries' balance of payments showed dramatic improvements and the earlier fears evaporated-indeed, international bankers began to
worry instead that they would make early debt
repayments or refinance on more favorable
terms.
After the initial oil shock, Korea reduced its
trade deficit primarily by continued export expansion, while Taiwan acted by drastically reducing its imports. This difference in adjustment
paths largely reflected differences in exchangerate policies-in particular, Korea's 18-percent
devaluation in 1974 on top of Taiwan's 5-percent
appreciation in 1973. In Cheng's words, "The exchange-rate changes made Korea's export expansion possible and Taiwan's import
contraction inevitable. The different adjustment
paths meant, for Korea, sustained output growth
at the expense of domestic price stability, and for
Taiwan, income stagnation coupled with a low
rate of domestic inflation."
During the 1975-77 period, however, both
countries' trade balances improved rapidly, primarily because of world economic recovery coupled with high world-income elasticities of
demand for the two countries' exports. Indeed,
Cheng notes that the world's income elasticities
of demand for Korea's and Taiwan's exports are
substantially larger than these countries' income
elasticities of demand for imports. The differences help account for a long-run rising trend in
both countries' export-import ratios.
creases in the money supply. In both the 1957-67
and 1967-77 periods, he finds statistically significant evidence of a relation between a country's rate of money-supply growth and its
inflation rate. Using Granger causality techniques, he finds that the causality runs from
money growth to inflation rather than the other
way around. The only two exceptions have the
wrong sign, indicating that a rise in the price levelleads to a decline in the money supply. Pigott's
analysis suggests why this has occurred in Japan's case-the Japanese authorities have acted
to reduce money growth when faced with a rising
inflation rate relative to abroad.
Bazdarich investigates four factors which have
been said to affect money-supply growth and
therefore inflation-increased wage demands,
the OPEC oil-price hike of 1973, government
deficit spending, and the international transmission of inflation from abroad. Given the moneyprice results, these sources of pressure would
have to have a systematic effect on moneygrowth rates if they were systematically responsible for persistent inflation. But here, Granger
causality tests showed little causal effect on money-supply growth from these commonly reputed
"inflationary" disturbances, so that they cannot
be considered sources of continued inflation.
Thus he asks, "If none of these factors have been
consistent causes of inflation, why have the Pacific Basin countries experienced monetary expansion and inflation? One explanation that is
consistent with our results (although obviously
not proven) is that monetary policy has been truly discretionary, designed to manipulate the ups
and downs of the business cycle."
In a third article, Hang-Sheng Cheng contrasts
the different approaches toward balance-of-payments adjustment taken by fast-growing Korea
5
Charles Pigott'
rational expectations, implies that policy rules
relating money growth to observable variables,
such as past employment or prices, will be used
by private agents to forecast future money
stocks. Secondly, they assert that anticipated
money-stock changes do not influence real output even in the short run. Under this hypothesis,
variations in prices, rather than real spending,
absorb predictable fluctuations in money growth
rates.
These two propositions imply that counter-cyclical monetary policy has no systematic effect
on real variables once private agents determine
how the authorities conduct their policy. Once
the policy is known, the changes in the money
supply it produces are predictable, so that they
then cease to influence real activity. If this
view is correct, a rule prescribing steady money
growth becomes more desirable. Such a rule then
is no less effective than any other in smoothing
business cycles, and may possess the additional
virtue of minimizing uncertainty about official
policy.
This article attempts to test whether Japanese
real growth in the 1957-77 period was systematically influenced by the changes in the Japanese
money stock that could have been predicted by
an informed economic observer. Evidence that in
the U.S. predictable money growth had no influence on real activity has been presented by Barro
(3,1977) and Sargent (8,1976). More generally,
the article examines whether anticipated and unanticipated money growth had different impacts
on Japanese real output.
In section I of this paper, we review several theories concerning the impact of counter-cyclical
monetary policy, and examine the assumptions
underlying the contention that it is ineffective. It
is argued that because of "frictions" such as contractual wage and price agreements, counter-cyclical monetary policy may influence output even
if expectations are fully rational.
Scholars of postwar Japanese economic history
generally agree that Japanese monetary policy
has significantly influenced the cyclical variations in the nation's economy. According to a
common view, the authorities reacted to reserve
losses during the 1950's and 1960's by slowing
the rate of monetary expansion, thereby reducing
the growth of investment and real GNP. Monetary policy was the government's primary
counter-cyclical policy tool throughout most of
this period, since deficit finance was severely
constrained both by law and by the relatively underdeveloped state of Japanese capital markets.
This explanation reflects a widely held view of
the influence of monetary policy upon economic
activity. Until recently, most economists believed
that, despite the lack of any permanent relationships, variations in money growth exert a significant and systematic temporary influence on real
growth and unemployment. This view, supported
by statistical analyses of the various empirical relationships involved, implied that counter-cyclical monetary policy can, in principle, reduce
fluctuations in real income. Because of the wide
acceptance of this hypothesis, debates about
counter-cyclical monetary policy have tended to
focus on whether enough is known about the timing and magnitude of the effect of money-stock
changes for such a policy to be effectively employed.
Recently, however, several economists have
suggested that counter-cyclical monetary policy,
as normally implemented, exerts no systematic
impact on real economic activity in either the
short run or the long run. Their argument rests
on two distinct contentions.
First, they claim that private agents intelligently use all available information in forecasting economic events. This hypothesis, known as
*Economist, Federal Reserve Bank of San Francisco. Norman Carleton, Janice Grubb, and Benny Yu provided research assistance for this paper.
6
Section II presents an equation explaining Japanese Ml growth over the 1957-77 period, and
uses this to estimate the anticipated component
ofmoney changes. Section III tests the relationship between changes in the money stock and
real economic activity. The results, although far
from conclusive, suggest that anticipated money
growth· temporarily influenced the growth of
Japanese industrial production and of real GNP.
They also suggest that anticipated and unanticipatedcomponents of money growth had qualitativelydifferent impacts upon Japanese economic
activity.
I. Theories of Counter-Cyclical Monetary PoliCY
Developments of the last several years have
raised doubts about the value of monetary and
fiscal policies in combatting cyclical variations
in income and employment. Traditional stimulus
instruments----tax cuts, public-wol'ks expenditures, expansive monetary measures-that
seemed effective during the 1960's appear now to
have lost their effectiveness in many industrial
countries. Public confidence in "fine-tuning" is
at a low ebb.
Partly as a result of these events, theoretical
views of the impact of counter-cyclical policies
have changed substantially. This revision has
centered around the theme of expectations:
how agents form them and how they influence
behavior.
These developments are illustrated by the evolution of theories about the influence of monetary policy on economic activity. During the
1960's, many economists believed that there was
a stable-and in practical terms, permanenttrade-off between inflation and unemployment.
The implication was that government could reduce the average unemployment level by increasing the long-run inflation rate through expansionary monetary policy. This view greatly
influenced macro-economic policy in the U.S.
and other industrial countries. 1
As theoretical attempts to justify this hypothesis failed-and as the trade-off became increasingly unstable beginning in the mid-1960'smost economists came to view significant systematic associations between inflation and unemployment as temporary. The new theories
developed to explain the short-run relation between these variables came to be based on the
propositions that a) unemployment is influenced
by unanticipated but not by anticipated variations in the price level; and b) in the long run,
actual and anticipated inflation rates are equal.
Hence an increase in the inflation rate could
have only a transient influence on economic activity.
However, because such theories required only
that actual and. anticipated price changes coincide eventually, they generally left open the
possibility that monetary policy could systematically influence real output over the business cycle. In empirical applications, expected price
changes were normally assumed to depend on
past inflation and (in some cases) other variables
in a manner invariant to changes in government
policy. This implied that the authorities could
successfully conduct counter-cyclical monetary
policy by relating unanticipated price and money
changes to past fluctuations in activity, as we will
see below.
The theory of "rational expectations," introduced by Muth (6, 1961) and developed further
by Barro (2,1976), Sargent (8,1976), Lucas (5,
1975) and others, considerably refined the formulation of expectations in such models by making anticipations depend explicitly upon the
structure of the economy and government policy.
But, when combined with the assumption that
predictable money changes have no influence on
real activity, this view implies that counter-cyclical monetary policy is ineffective once the
private sector determines how the policy is conducted.
Tile Phillips curve
To illustrate the implications for monetary
policy of these different views, consider a simple
model of the unemployment rate.
u(t) = ao + alu(t-l) + a2u(t-2) + Z + e(t) (1)
where u(t) is the unemployment rate at time t,
e(t) is a random disturbance, and Z is a set of
other variables influencing unemployment, including policy instruments. The unemployment
rate is affected by its own past values because of
delayed responses of consumption and invest7
menttoincome and other lagged relations. Becauseofthis dependence, a change in u (t) caused
by the disturbance leads to further changes beforeullemployment returns to its long-run level.
In this. way, fluctuations in unemployment that
resemble business cycles are produced. This
processis described in detail by Larry Butler in
the spring 1977 issue of this Review. 2
Counter-cyclical policies are designed to reducethe severity and duration of business cycles.
This is done. by using the government's instrumentscol1tainedin Zto offset the effects of past
fluctuations inu(t); This, in effect, changes the
relation. between current and past unemployment. and reduces business-cycle fluctuations.
The controversy raised by rational expectations
centers about how the government accomplishes
this task.
During the 1960's it was widely believed that
one element of Z was the actual change in prices
Lip(t) (=p(t) - pet-I). This relation was known
as the "Phillips Curve".3 A simple version of this
relation can be written as:
u(t) = ao + alu(t-l) + a2u(t-2)
- a3Lip(t) + e(t)
(2)
where a3 is positive. This implied that the government could, by varying money-supply growth,
manipulate price changes, thereby influencing
unemployment. In addition to smoothing economic cycles, the appropriate choice of moneystock growth could influence the long-run rate of
inflation, and thus permanently alter the average
rate of unemployment as well. 4
Natural-rate hypothesis
This view of the relation between monetary
policy and economic activity has now been largely discarded by economists. Current theories
generally incorporate the "natural rate" hypothesis that trade-offs between inflation and unemployment are at best temporary, although possibly long-Iived. s
This hypothesis says that the unemployment
rate is equal in the long run to a value, known as
the "natural rate of unemployment", which is determined by the cost of searching for jobs, the demographic composition of the labor force and
other factors. The natural rate is assumed to be
unaffected by changes in the money stock or inflation. This reflects a proposition known as
the "neutrality" of money, which asserts that a
cha.nge in money leads eventually to a proportionaLchange in all prices~leaving unaffected
all relative prices and all determinants of the naturaL rate. The proposition follows intuitively
fromithe observation that a typical individual
whose money holdings are doubled while all
pricesareraisedinthe•• same. proportion has pre9is~lytlles~l11ereaLincome and real money balances, and· therefore the same opportunities for
consumption· and leisure,· as he did previously;
thus his behavior should not be altered. 6
MosFforIlll.llations of the· natural-rate· theory
aSSume that predictable changes in money have
the same effects in the short run as in the long
rUn. Anticipated money-stock changes are often
assumed to lead immediately to proportional
changes in all prices, leaving unemployment and
realoutput unaltered. This implies, in effect, that
individual spending decisions depend only upon
current and future relative prices and real money
balances, and not upon variations in the level of
prices.?
Natural-rate theories attribute temporary associations between unemployment and inflation
to unanticipated changes in money and the price
level. According to one account, an unexpected
rise in the money stock raises aggregate demand.
Becausethe increase in the total money stock is
not immediately perceived (in part because reiiable statistics are published with a lag), firms
generally confuse the increase in aggregate demand with an improvement in the market for
their own products. Firms then move up their
supply curves, increasing employment, output
and prices. However, once the money-stock increase becomes known, output and employment
return to their normal levels. Natural-rate theories thus imply that an unanticipated money-stock
increase initially stimulates activity. Furthermore, because a sustained increase in the growth
rate of money must eventually become anticipated, its influence on economic activity cannot be
permanent. 8
Tile natural rate and counter-cyclical policy
A simple version of the unemployment relation
implied by natural-rate theories is:
u(t) :=ao + alu(t-I) + a2u(t-2)
-a3(Lip(t) - Lip(t)e) + e(t)
(3)
where now Llp(t)e is the change in the level of
8
prices anticipated by economic agents. As explained above, a3 is generally assumed to be positive. 9
In contrast to the earlier unemployment relation, this implies that a sustained change in the
growth of the money stock has no permanent influenceon ecollofuic activity. This is because
money-stock changes, and the inflation they
cause, eventually become anticipated; that is
.ip(t) = Ap(t)e in the long run. Hence, the unemployment rate returns to its "natural" level.
However, until recently formulations of this
theory implied that counter-cyclical monetary
policy could at least exert a short-run influence
on economic activity. The reason is that expectations about prices and money growth were assumed to be formed in a manner that did not
directly depend upon government policy. Under
"adaptive" expectations, for example, expected
prices changes were a function of past inflation:
n
.ip(t)e = ~h(i).ip(t-i)
(4)
i=l
where the h(i) were assumed to be fixed (the h's
sum must also equal one if a permanent increase
in inflation is eventually anticipated).
Assume, for illustrative purposes only, that
prices immediately adjust to current moneystock changes Am(t); that is, that Am(t) = Ap(t).
Then even in this simple case, a counter-cyclical
policy rule of (say) the form:
.im(t) = cou(t-l)
(5)
will influence cyclical fluctuations in unemployment. To see this, substitute from (5) into (4) to
relate expected price changes to past unemployment:
Then, since actual price changes equal current
money. stock changes, unemployment can be
written as:
u(t) = ao
~h(i)·cou(t-i-l)
+ a3co~h(i)u(t-i-l) + e(t)
The last two terms in unemployment have been
added by the counter-cyclical policy and the expectations mechanism (4). These terms change
the size and duration of the fluctuations in unemMore generally, a "reaction" function relating
money-stock changes to past unemployment can
be designed so that business-cycle fluctuations
are reduced. This process is illustrated in Diagram (1). A rise in unemployment caused by the
disturbance "e" leads, through the action of the
monetary authorities, to an increase in the money stock, "m," and then to an increase in the price
level, "p". The price level expected by individuals, "pe", also rises, but by less than the actual
increase in prices. As a result, unemployment is
pushed back down toward its natural rate. As
this example indicates, stabilization policy is effective because the authorities are able to make
the difference between actual and anticipated inflation depend upon past unemployment. They
can do this because the relation used to forecast
price fluctuations does not change when policy is
altered. 10
Influence of rational expectations
Rational expectations refers to an economic
theory explaining how individuals predict economic events. Because the theory has most often
been applied to models incorporating the natural-rate hypothesis, the two have sometimes been
(6)
Diagram 1
uA
(7)
i=l
i=l
eA
- a3cou(t-l)
n
n
.ip(t)e =
+ alu(t-l) + a2u(t-2)
mA
9
the government to combat business cycles. But
when this happens the policy becomes ineffective, because it produces only predictable variations in prices and money. This is illustrated in
Diagram (2). As before, a rise in unemployment
leads to an increase in the money stock. However, under rational expectations, anticipated price
changes,
~p(t)e = cou(t-I)
(8)
are exactly equal to actual price changes. Unemployment and the business cycle are thus unaffected. 12
confused,Theconceptsare actually quite distinct, and indeed rational-expectations. theory is
just as applicable to models in which the naturalrate hypothesis is invalid as to those in which it is
correct.
RatiOnal:expectatioIls theQry asserts that privateagents forecast economic events in much the
sam~ rnanneraseconomists. That is, agents use
pastdataandtheir knowledge of behavior to estimaterelationsamongeconomicvariables~and
thus to forecast future developments.•In this. re.
spect, the rational-expectations model is little
different from other forecasting models incorporatedin most natural-rate formulations: all implythatagentsuse past data to predict economic
variables. l1 However, rational expectations also
implies that individuals continually update their
prediction schemes on the basis of new information. This means that when economic behavior
changes~in particular, when government policy
isaltered~individuals' forecasting relations are
changed also. According to this aspect of the theory,anY counter-cyclical monetary policy based
entirely on agents' misperceptions about prices
and other observable variables must eventually
become ineffective.
To see this, consider again the model summarizedin relations (4) through (6). Countercyclical policy is effective in this case because individualsunderpredict actual price level changes
when. unemployment is above its natural rate,
while they do the opposite when unemployment
is below the natural rate. Rational-expectations
theory asserts that individuals notice these relations. They then improve their predictions by
raising their original forecasts when unemployment is high and reducing them when it is low. In
this way, agents discover the policy rule used by
This viewofcollnter-cyclical· monetarypblicy
is not widely accepted. Most .economists believe
that counter-cyclical monetary policy can influence unemployment and real output in the short
run, but that it has no significant permanent effect. Some economists, skeptical about the policy
implications of combined natural rate and rational expectations theories, have questioned the
practical validity of the rational expectations hypothesis.
Rational expectations is, however, simply one
aspect of the more general assumption that individuals are rational. Economists normally assume that individuals are able to maximize their
satisfaction (given their income) and that firms
are able to minimize costs (given available resources). But this hypothesis is tenable onlyif
economic agents effectively use· all information
available to them. Rational-expectations theory
merely asserts that agents do just that when predicting economic variables.
On the other hand, less plausible assumptions
underlie those theories in which only unanticipated price and money-supply changes influence
economic variables. Such theories generally as-
Diagram 2
eA
u-
10
have a negligible impact on real aggregate demand, whiIeothersassigna more prominent role
to such changes. Indeed, in many large econometric • . m(}dels""-including several for Japan 15temporary variations in liquidity caused by
changes in money growth significantly affect at
least some spending components.
Predictable changes in money growth thus may
exertsignificant temporary impacts on economic
activity, even when expectations are rationally
formed .• More generally, the impact of both unanticipated and .anticipated money growth may
vary with institutional factors. For example, the
effect of anticipated money growth on activity
may depend on the degree to which prices and
wages fluctuate with variations in the money
stock, as argued above. This impact may also depend upon the extent to which close substitutes
for money are available to individuals and firms,
as well as other factors. Consequently, the influence of anticipated and unanticipated money
growth could vary among countries. Barro (3,
1977) and Sargent (8,1976), on the basis ofU.8.,
evidence, suggest that anticipated money growth
has no influence on economic activity, but the
evidence presented here would suggest otherwise
for Japan.
sume that there are no institutional impediments
to free, continuous· adjustment· of prices and
wages. Perceived money-stock changes are often
assumed tolead immediately to offsetting pricelevel movements, leaving unaffected such variables as agents' real money balances, real output,
and the relative prices of goods and factors. Predictableattemptsby the government to restrict
or expand money-supply growth then only produce offsetting price-level fluctuations, with no
dffdcforiecollol11icactivity.
Prices and wages are not actually adjusted in
this l11a.ririet.Sol11e product and factor prices are
contractually set for fixed periods. Others that
appear variable in principle are not actually so,
but instead tend to respond primarily to long-run
rather than cyclical fluctuations in demand. ALthough the reasons for such behavior are not
entirely understood, the implication is that variations in money growth produce temporary fluctuations in private real-money balances. 13
Theoretically, such transient variations in real
balances can influence economic activity: individuals with temporary excess cash may choose
to increase their spending, for example. 14 Economists differ, however, about their actual impact.
Some believe that fluctuations in real balances
II. Testing the Hypothesis: Estimation of Anticipated Money Growth
anticipated money changes influence real output
must still be tested.
Testing this proposition is complicated by the
fact that expectations are not directly observable. But following the procedure adopted by
Barro (3, 1977) in his U.S. study, we can estimate the anticipated components of money
growth under the assumption that agents' predictions are rational in the sense defined earlier.
More exactly, we can develop a "prediction"
equation relating historically observed moneystock changes to other variables; on the assumption that economic agents had at least a rough
knowledge of this relation, we may use the fitted
values from the equation as estimates of anticipated money growth. The unanticipated components are then defined as the actual changes
minus the predicted elements.
If this procedure is to be acceptable, the estimated predicted money-growth components
The hypothesis concerning the relationship between anticipated money-stock changes and Japanese economic activity is particularly significant for Japan because few other industrial
countries have relied so heavily on monetary
policy as a tool of stabilization policy. Indeed, the
Japanese until recently have utilized fiscal policy, by and large, only to accomplish longer-term
economic objectives. 16
Various studies-such as Keran (4, 1970) and
the OECD (9, 1972)-suggest that Japanese
monetary policy has affected real output in a
substantial and systematic way. However, these
studies do not distinguish between anticipated
and unanticipated components of money growth,
and thus do not directly reveal the impact of predictable counter-cyclical changes in the money
stock. Indeed, it is possible that such estimates
reflect the impact on real activity of unanticipated money growth only. Thus the hypothesis that
11
must be based on commonly available data. Accordingly,theiequationdeveloped i here related
a()tualmon~ygrowthduring a given quarter to
data from earlier quarters. Similarly, the relatiQnshouldbe .consistent with the processes
actuallyd~termining •.money-stock.changes=es"
peciaHy •officialpolicies--,duringthe. period exarnil1ed.F'or this reason, it will be useful to
briefly review Japanese monetary policy over the
1951-71 period.
Japane$e •mouetarypoUcy
As many. writers have emphasized, Japanese
monetary policy is heavily influenced by institutional Jactors.Large-scale .open-market operationshavenot been feasible, so that centralbank credit has provided the primary source of
the banking system's reserve growth. As a result,
the major commercial banks are net debtors to
the Bank of JapanY
Consequently, the Bank of Japan has exerted a
substantial de facto influence on bank lending
policies. This influence has been reinforced, particularly during the 1960's, by "window guidance", an informal device whereby the central
bank fixes ceilings on individual banks' aggregate lending as well as on their credit to particular sectors. Although there is no legal basis for
the ceilings, the Bank's wishes have generally
been respected. Thus the Bank generally has
been more successful than the central banks of
other major industrial countries in implementing
its objectives for money growth. 18
Japan's money stock has grown very rapidly
over time, reflecting the nation's exceptionally
rapid economic growth. Money stock (M 1)
growth averaged 16.5 percent annually from
1957:1 through 1977:3, compared to 4.4 percent
for the U.s. over the same period. In contrast to
the US., Japan's average rate of money growth
was the same over the latter half of this period as
during the first half (Table 1).
Over shorter time periods, however, Japanese
M1changeshavefluctuated substantially (Chart
1). For example, money growth was below average,iandmonetarypolicy was relatively restrictiv(:,fromroughly1961:2 through 1962:2 and
agllinfrom1963:3 through 1964:4. Money
growth waS relatively • rapid over •the interval
1962:4 to 1963:2,. during 1971, and from mid1972 through mid-1973. 19
[)uringthe1950'sand 1960's, periods of monetaryrestriction were normally initiated by a deterioration in Japan's balance of payments, while
periods of ease normally occurred when economicactivity hadslow.ed sufficiently to restore external balance. AccQrding to most accounts, a
business-cycle expansion typically would lead to
atraqedeficit, producing a deterioration in the
balance of payments and international reserve
outflows. The resulting drain in private bank reserves, combined with Bank of Japan credit restrictions, w.ould then lead to a deceleration of
money growth and force a reduction in the exPansionofprivate bank credit. The reduction in
bank.lending (these accounts assert) particularly
affected the corporate business sector-which is
heavily dependent on commercial banks for external funds-and through it private investment.
Japanese monetary policy thus was aimed
more at offsetting the impact of business-cycle
fluctuations on official reserves, than in reducing
variations in real income. 2o For example, the declineintheM 1 growth rate from 1961:2 through
1962:2 was accompanied, indeed preceded, by a
faHin the growth rate of gold and foreign-exchange reserves. The pattern was similar, although less pronounced, during the subsequent
cycle in money growth from 1962:2 through
1964:4 (Chart 1).
Systematic relations between Japanese M 1
growth and reserve fluctuations diminished considerablyafter 1970. Japanese reserves increased
dramatically in 1971 as the government initially
resisted revaluation of the yen. As a result of this
accu.mulation ofreserves, the Bank of Japan had
much less need to use monetary policy to offset
temporary balance-of"payments fluctuations. 21
Japan's economic environment changed even
more dramatically beginning in 1973. The advel)tofgeneralized floating freed the Bank of the
obligation (although not necessarily the desire)
Table 1
Japanese and U.S. M 1 Growth Rates
(seasonally adjusted annual rates)
Period
Japan
U.S.
1957:1-1977:3
16.5
16.5
16.5
4.4
1957:1-1967:4
1968.1-1977:3
3.0
6.0
12
Chart 1
Changes in Japanese Money Supply (M 1)
and Gold and Foreign Exchange Reserves
Change in Logs
Change in Logs
9.0
90.0
80.0
70.0
60.0
4.0
40.0
3.0
30.0
2.0
20.0
1.0
10.0
o
o
-1.0
-2.0
-10.0
!
-20.0
-3.0 1~57
1978
of continuously defending a fixed exchange rate.
This development further weakened the direct
influence of reserves on domestic money. In addition, inflation accelerated sharply, leading the
government eventually to reduce money growth
in order to bring price increases back to historical
rates. This suggests that fluctuations in Japanese
money growth after 1970 may be better explained by variations in foreign and domestic inflation rates than by changes in reserves.
Prediction equation
A statistical analysis of Japanese money-supply changes supports these observations. (In
choosing a measure, M 1 data was used to facilitate comparisons with other studies of the determinants of Japanese money growth.)22 Prior to
1971, variations in M 1 growth appear to be positively and significantly related to changes in Japan's gold and foreign-exchange reserves.
Subsequently the two are not significantly associated. Instead variations in M, growth appear to
be more closely related to the difference between
-30.0
Japanese and U.S. consumer-price inflation.
Since maintenance of a stable exchange rate requires that domestic and foreign prices of similar
goods grow at the same average rate, this relation may reflect the Japanese authorities' attempt to prevent large changes in the dollar value
of the yen, even under floating exchange rates.
A number of equations explaining Japanese M,
growth fit the 1957-77 sample period about
equally well. Generally the more complex the estimated relation, the greater the likelihood that
variables will be included that were not actually
used by individuals to forecast M 1 growth. The
"predicted" M 1 changes estimated from such a
relation will then include a portion of money
growth that was actually unanticipated; anticipated changes may then appear to affect activity
when in fact their influence reflects the impact of
unpredicted M, changes. For this reason, a relatively simple relation explaining M 1 growth was
chosen (Table 2).
To see how Japan's balance of payments af-
13
fected her money stock in the pre-1971 period,
suppose that the growth .of reserves rises for a
single quarter by one percentage point. The
~uationimpliesthat M 1growth will be raised by
'~~percent in the next quarter and by .05 percent
in the quarter thereafter. This response reflects
tllefacnhat Japanese gold and foreign exchange
reserves were only about 7 percent of Japanese
M 1 during this period; the equation also implies
that a decline of one dollar in reserves led to a
t()~alfall ofroughly 520 yen in Japanese M 1over
the next two quarters, or nearly 1.5 dollars at the
e~chal1geratethen prevailing. 23
The post-1970 equation suggests that the Japanese authorities manipulated money growth to
ke.ep the Japanese-U.S. inflation relationship
within a range consistent with a stable exchange
rate for the yen. Suppose that the ratio of Japanese to U.S. consumer prices rises for one quarter
by one percentage point. The equation implies
tllatJa.l>am~seM1 eventually declines by 1.25
percent (Table 2). That is, Japanese money, and
eventl1ally Japanese prices, subsequently fallby
nearly the same proportion as the initial increase
in the relative inflation rates. Thus the authorities apparently attempt to offset changes inrelative inflation rates in order to maintain a stable
exchange rate. As Chart 2 indicates, the general
pattern of variations in actual M 1 growth in both
periods is reflected reasonably well in the
values.
Measures of anticipated .and unanticipated
money growth can be extracted from these prediction ~uations. Anticipated money growth is
defined as the values of M 1 growth predicted
from the equations in Table 2. Unanticipated
money growth is simply the difference between
actual and anticipated money changes. These
Table 2
Money Prediction Equations 1
Period: 1958:1 - 1970:4
DMIA(t) = .02 + .044 X DRSA(t-l)
(4.43)(1.21)
+ .052 X DRSA (t-2) + .209
(1.35)
X DMIA(t-1)
(1.41)
+ .226 X DMIA(t-2)
(1.75)
Period: 1971:1 -1977:3
DMIA(t) = .020 - .533 X (DJCPI (t-2) - DUSCPI(t-3»
(4.43) (-3.00)
+ .576
X DMIA(t-l)
(5.41)
Summary Statistics for the Entire Sample
R2 (adjusted)= .36
Standard Error= .015
1958: 1-1970: 43 = .012
1971: 1-1977: 43 = .017
Rho= .009
Durbin-Watson= 1.97
Sample Period= 1958:1-1977:3
Number of Observations= 79
Memorandum: Sum of Coefficients of DRSA= .096
(2.88)
Notes: 'The estimates were derived from a single equation applied to the entire sample, using multiplicative dummy variables.
2DMIA = Difference between the current and previous quarter's logarithm of seasonally adjusted M,.
DRSA= Difference between the current and previous quarter's logarithm of seasonally adjusted gold and foreignexchange reserves.
DJCPI = Difference between the current and previous quarter's logarithm of the Japanese CPI.
DUSCPI = Difference between the current and previous quarter's logarithm of the U.s. CPI.
3This is the square root of the sum of squared residuals divided by the number of observations; these are not strictly
comparable with the standard error of the entire sample.
'Figures in parentheses are "T" statistics.
14
Chart 2
JapalleseMoney Supply (M 1) Growth Rates
Actual and Predicted Values
Change in Logs
Change in Logs
;::f
6.0
5.0
4.0
3.0
1\
l;::
J
,
~.~
...
5.0
\.
<'\
\ I
'\. II
l6.0
"'ed'ctod
4.0
\
3.0
'<
2.0
Actual
2.0
1.0
1.0
o
o
-1.0
-1.0
-2.0
1978
components can be used to test the extent to
which predicted M, growth influenced Japanese
economic activity.
As we have seen, however, the relation explaining money growth apparently changed in 1971.
The predicted M, changes are most likely to reflect expectations held by economic agents if the
-2.0
relation has been fairly stable over a long period
of time. Under such circumstances, it is reasonable to suppose that individuals at least had an
approximate knowledge of the relation and could
have used it to forecast. When (as appears to
have been the case) the relation changes significantly, this presumption becomes less plausible.
m. Impact of Anticipated and Unanticipated Money Changes
on Japanese Economic Activity
Three separate hypotheses should be tested: 1)
that neither anticipated nor unanticipated
changes in the money stock influence economic
activity in the long run; 2) that anticipated money-stock variations have no impact on real activity; and 3) that unanticipated money-growth
changes stimulate real activity in the short run.
The first proposition is simply the natural-rate
hypothesis; it does not preclude a short-run influence of money on real output. The second hypothesis-the focus of this article-suggests that
counter-cyclical monetary policy will have no
systematic influence on activity once agents
determine how the policy is being conducted.
The third proposition is frequently used to explain temporary unemployment-inflation-money
growth relationships.
These propositions are tested here by regressing alternative measures of real activity on their
own past values, and on current and past values
of the estimated (predicted and unpredicted)
components of money
In addition, a time
trend is included to allow for secular changes in
real growth. The two dependent variables examined are changes in the logarithms of Japanese
industrial production and real GNP. Industrial
production is included because, according to previous studies, money-growth variations particu~
larly affect the· corporate-business sector, and
hence industrial activity. The reader interested
primarily in the conclusions may wish to skip the
unavoidably technical "Analysis of estimates".
15
Table 3
Summary of Regressions of the Activity Variables on the
Money Growth Components
Changes In:
Log of Real
Log of Industrial
Regressors
GNP
Production
Constant
Time
Anticipated Money Changes - Lag sums:
0-2
3-7
Unanticipated Money Changes - Lag sums:
2
3- 7
Lagged Dependent Variables (sum)
2.36
-.02
(3.06)
(-2.33)
2.50
-.02
(4.07)
(-2.72)
1.20
-1.20
(3.91)
(-3.91)
.35
-.35
(1.27)
(-1.27)
-.23
.23
(-.96)
(.96)
.06
-.06
(.32)
(-.32)
.56
(4.85)
.30
(2.07)
Rho
R2(adjusted)
-.03
.73
-.58
.30
Standard Error of Regression
Number of Observations
Period
1.38
1.34
71
1960:1 - 1977:III
71
1960:1 - 1977:III
The basic equation was:
7
7
4
ilX(t) = aO
+ al
Sources: i)
ii)
Notes: 1)
2)
Industrial Production: OECD Main Economic Indicators, Historical Statistics.
Real GNP; Investment: OECD Quarterly National Income Accounts.
Figures in parentheses are "T" statistics.
Industrial Production and Real GNP are seasonally adjusted.
XT
+ ~a2(i)DMP(t-i) + ~a3(i)DMR(t-i) + ~a4(i) X (t-i)
i=O
i=O
i=1
where AX(t) is the activity variable, T is a time trend, DMP is predicted money growth and DMR is unanticipated money
growth. The AX, DMP, and DMR were also expressed as percentages (i.e. multiplied by 100). A Cochrane-Orcutt correction for
first-order serial correlation of the disburbance was also applied.
Table 4
Summary of Statistics Testing the Hypotheses+
HO
H1
H2
H3
Change in the Logarithm of Industrial Production
0.48
6.42**
3.14*
3.91 **
Change in the Logarithm of Real GNP
0.03
2.35*
0.55
1.36
HO:
HI:
H2:
H3:
+
**
F test of the hypothesis that the sum of the coefficients of anticipated and unanticipated money growth are zero. The
hypothesis is rejected at the 5-percent level (with 50 degrees of freedom) if the statistic exceeds 3.18.
F test of the hypothesis that all the coefficients of anticipated money growth are zero, against the alternative that some of
the coefficients of both components may not be zero. The hypothesis is rejected at the 5-percent level (with 50 degrees of
freedom and seven restrictions) if the statistic exceeds 2.20.
F test of the hypothesis that the coefficients of unanticipated money growth are all zero, against the same alternative as in
H I. The critical 5-percent value is also the same.
F test of the hypothesis that all the coefficients of both money components are zero. The hypothesis is rejected (with 50
degrees offreedom and 14 restrictions) if the statistic exceeds 1.90.
Since a Cochrane-Orcutt procedure was applied, these statistics are only asymptotically distributed as "F".
Significant at the 5-percent level.
Significant at the I-percent level.
16
Analysis of estimates
The estimates were obtained by allowing lags
of seven quarters for the money-growth components and four quarters for the lagged dependent
variables. 24 The results are summarized in Tables
3 and 4. To simplify the presentation, only the
sums of the coefficients over the indicated lags
are listed in Table 3, while the individual coefficients are listed in Appendix A.
Japa.nese industrial production and a smaller but
still significant effect on real GNP. As shown in
the second coblmn of Table 4, the hypothesis that
all the predicted money growth coefficients are
zeroiseasily rejected (at weU above the 1 percent
confidence level) for industrial production, and
can als(fberejected for real GNP: at least some
of these coefficients then .• differ significantly
from zero. Thus, contrary to most formulations
of the natural-rate hypothesis, anticipated moneygrowth has had an effect em Japanese economic activity.
Finally, unanticipated money growth apparently shows a much different impact than anticipated money expansion. The hypothesis of zero
influence on activity-that is, aU zero coefficients--can be rejected for industrial production
but not for real GNP, as seen in the third column
of Table 4. An unanticipated rise in M 1 initially
raises real-output growth; however, this effect is
relatively small and statistically insignificant
(Appendix A and Table 3). But in the following
two quarters, the growth of real output is actually depressed by the unpredicted money increase.
Thus the natural-rate hypothesis-that unanticipated money growth stimulates real activity-is
not supported by these results. Any stimulus
from unanticipated money growth apparently
was both small and temporary-at least in Japan,if not the U.S.
Assume that M, increases for one quarter by
The results support the natural-rate hypothesis
thatmoney-stock changes exert no permanent
influence on economic activity. This. hypothesis
implies that the sums of the coefficients of anticipated and unanticipated money growth both
equal zero. In other words, an acceleration in
economic activity following an increase in money
must be fully offset by a later deceleration in production if the level of activity is to be unaffected
in the long run. 25 As shown in the first column of
Table IV, the long-run natural-rate hypothesis
could not be rejected at the 5 percent confidence
level for either of the relations. Variations in M,
growth thus showed no long-run impact on either
Japanese industrial production or real GNP.
Consequently, the natural-rate hypothesis is imposed on the estimates presented in Table 3, and
this relationship holds for the remainder of this
discussion. 26
Anticipated money growth apparently had a
substantial and significant short-run impact on
Table 5
Impact of a One Percent Rise in the Money Growth Rate
Sustained Over One Quarter
Quarter
Percentage Rise
in Quarterly
Money Growth
I
1.0
2
3
4
Percentage Rise in Growth
of Industrial Production if:
Anticipated
Unanticipated
.52
.03
o
.78
o
o
o
o
.61
-.79
-.07
-.20
-.53
.51
.13
.12
.09
-.18
II
o
o
o
o
o
-1.37
-.07
-.16
-.19
12
o
-.01
5
6
7
8
9
10
.00
17
Percentage Rise in Level of
Industrial Production if:
Anticipated
Unanticipated
.52
1.30
1.91
1.12
1.63
1.75
.38
.03
-.04
-.24
-.77
-.64
-.55
-.73
-.39
-.22
.34
.31
.17
.15
.09.
.09
.04
-.04
12
-.04
-.05
-.02
.00
one percentage point. If the increase is anticipated, the growth of industrial production is immediatelyraised by one-half percent (Table 5).
IndustriaLproduction continues to rise above its
normal level, and by the third quarter it is nearly
two percent. above the level it would otherwise
hayereaqhc;:d.But subsequently, production declille~backtoward its •long-run level, and after
three years it is virtually unaffected by the anticipated M 1 increase.
If the Mjincrease is unanticipated, the impact
on industrial production is both qualitatively differentandmore modest in size, with an 0.8 percent.dec]ine below its normal level by the fourth
quarter. But again, the impact of the M 1 increase
is again largely dissipated after the end of three
years.
Implications of results
What do these results imply about Japanese
monetary policy over the 1957-77 period? First
of all, anticipated increases in money growth
stimulated real economic activity-particularly
industrial production-while anticipated reductions in money growth depressed activity. Countercylical monetary policy was thus at least
potentially effective in reducing Japanese business-cycle fluctuationsP The results are consistent in this respect with previous studies of
Japanese monetary policy. At the same time,
they are incompatible with those rational-expectations formulations of the natural-rate hypothesis that deny any systematic relationship
between counter-cyclical monetary policy and
real economic activity.
Indeed, the findings for Japan are nearly the
opposite of those obtained by Barro for the U.S.
Using annual data, he found that anticipated
money growth had no impact on the U.S. unemployment rate, whereas unanticipated money
growth led to a reduction in unemployment lasting for nearly three years. The results for Japan
imply that any stimulus generated by unanticipated money growth is, at best, small and quite
short-lived. Thus in Japan, the predictable part
of moneygrowth affected real output most heavily,whileinthe U.s., only unanticipated money
grqwthinfiuencedeconomic activity.
In.stitutional features possibly may account for
some of these differences in national behavior. In
Ja.pan,short-termcapital markets are lessdeveloped and>Close substitutes for money are thus
less available-than in the U.S. Moreover, Japanese corporations are strongly dependent upon
the private banking sector for external funds, becauseoflherelatively underdeveloped nature of
the bond and equity markets. This suggests that
Japanese corporations' expenditures may depend
more heavily on their real money balances than
do the expenditures of their U.s. counterparts,
and thus may respond more to anticipated money~growth fluctuations.
It is also conceivable that the contrasting results reflect differences in U.S. and Japanese
monetary policies during the period examined. In
Japan, M 1 grew (on average) at a stable pace,
whereas in the U.S. money growth generally increased from the mid-1960's through the early
1970's.28 This suggests that an unexpected acceleration of money in the U.s. was often followed
by further above-average increases; in Japan, on
the other hand, money acceleration was generally followed within several quarters by deceleration. Consequently, an unanticipated money
change in Japan, once perceived by individuals,
possibly could have had a more temporary impact on real balances than would have been the
case in the U.s. If true, this factor may help explain the apparently different impact of unanticipated money growth on real output in the two
countries. 29
The results must, in any case, be regarded as
tentative-particularly regarding the findings
for unanticipated money growth. 3D Nonetheless,
they suggest that, in Japan at least, counter-cyclical monetary policy can be used effectively to
reduce fluctuations in real activity.
IV. Summary and Conclusions
economic policies. During the late 1960's, many
economists believed that it would soon be possible to "fine tune" variations in economic activity-that the objectives of price stability and
The apparent failure in recent years of macroeconomic policy to alleviate conditions of simultaneous inflation and unemployment has disappointed many advocates of counter-cyclical
18
continuous full employment could be reconciled.
Recent proposals for the adoption of incomes
policies are, in part, an indicator of the current
disillusionment with the traditional macro-economic tools that were supposed to accomplish
these policy goals. Some economists have come
to question whether counter-cyclical policies
have (or indeed ever had) any consistent impact
on economic activity, even in the short run.
The resuits presented in this article suggest
that this view of the impotency of policy is not
applicable to Japan. If this conclusion is correct,
counter-cyclical policies can theoretically be
used to reduce business-cycle fluctuations. Officials who design and implement Japanese monetary policy are thus not irrelevant, as some
economists have in effect suggested. But the task
confronting them today is almost surely more
complicated than was generally believed during
much of the 1960's.
A decade ago, economists tended to bdieve in
the stability of the relationships among inflation,
employment, and real economic activity. In the
U.s., for example, the increase in inflation associated with a given reduction in the unemployment rate apparently remained constant for
wany years. Many economists thus came to believe that economic theory, aided by the sophisticated econometric models then being developed,
could exploit such relations to ameliorate the effects of business-cycle fluctuations.
It now seems clear that such relations, which
shifted distressingly often as inflation accelerated over the past decade, were actually more
complex than had originally been thought. Many
economists now believe that changes in prices,
money, and other variables that are anticipated
by private individuals have different effects than
those changes that are unanticipated. This view
helps explain why "stable" relations between inflation and unemployment fluctuated as monetary policy changed and as inflation accelerated
in the •U.S. and other industrial countries. According to this view, the amount of inflation associated with a given level of unemployment in the
U.S. is higher now than a decade ago, in large
partbecause actual and expected average money
growth has been higher than during the 1960's.
The results for Japan are quite consistent with
this approach. Apparently, anticipated money
growth substantially, although temporarily,
stimulates. real economic activity. Unanticipated
money growth apparently has a significantly different impact; it may raise activity for one quarter, but then seems to depress activity for some
time thereafter.
Thus, it appears that Japanese policy-makers
cannot mechanically manipulate private real activity in the manner suggested by the theories of
the 1960's. An official interested in determining
the impact of a given M 1 increase on real output,
for example, must first ask his staff how much of
the planned change is expected by the market.
And while policy-makers study the market's behavior, they must also know that the market is
studying their own reactions. If it were true that
predictable policy-generated changes in money
do not affect real economic activity, the task facing Japanese officials would be not only difficult,
but ultimately futile. Fluctuations in real income
could then be offset by monetary policy only to
the extent that the authorities were able to confuse the market about actual official intentions.
A policy of this type could hardly enhance officials' credibility. But the results derived in this
article suggest that Japanese policy-makers may
be both predictable and effective in using
counter-cyclical monetary policy.
19
1. Ackley, Gardner, and Hiromitsu Ishi, "Fiscal, Monetary and
Related Policies", in: Hugh Patrick and Henry Rosovsky (eds.),
Asia's New Giant, Brookings, 1976.
2. Barro, Robert J., "Rational Expectations and the Role of Monetary Policy", Journal of Monetary Economics (2), 1976, pp.
1-33.
3. Barro, Robert J., "Unanticipated Money Growth and Unemployment in the U.S.", American Economic Review, March.
1977,pp.101-115.
4. Keran, Michael. "Monetary Policy and the Business Cycle in
Postwar Japan". in: David Meiselman (ed.), Varieties of Monetary Experience, University of Chicago Press, 1970.
5. Lucas. Robert E., "An Equilibrium Model of the Business Cy-
207-237.
9. Organization for Economic Cooperation and Development,
Monetary Polley in Japan, OECo. Monetary Studies Series. December 1972.
APPENDIX A
Individual Coefficient Estimates
Changes In:
Regressors
Constant
Time
log of Industrial
log of Real
Production
GNP
(4.07)
2.36
-0.02
(3.06)
(-2.33)
2.50
-0.02
(....2.72)
0.52
0.51
(1.99)
0.47
-0.23
(-0.50)
Anticipated Money Changes:
Lag -0
I
2
3
4
5
6
7
(1.52)
(0.46)
(1.73)
0.16
-1.20
(-3.52)
0.11
-0.39
(-0.87)
0.89
-0.08
(2.40)
(-0.21)
0.56
-0.29
(-0.65)
-1.35
0.54
(-3.78)
0.19
( 1.87)
-0.42
(0.45)
(.... 1.72)
(0.24)
0.12
-0.10
(1.02)
(-0.63)
(0.24)
(1.28)
Unanticipated Money Changes:
Lilg
I
0.03
-0.09
(-0.61)
0
2
-0.16
(-1.10)
0.04
(g.2f))
3
4
-0.42
(-2.82)
-0.03
(-0.19)
0.43
(2.67)
5
0.06
-0.22
(0.34)
(-1.27)
0.23
-0.28
(1.31 )
(-1.56)
0.01
(0.00)
0.38
(2.26)
0.02
(0.13)
Lag -1
0.53
(4.15)
0.43
(3.51)
2
(0.46)
0.06
(0.41)
3
0.06
0.Q7
(0.55)
4
-0.10
(-0.90)
0.02
-0.20
(0.18)
(-1.69)
6
7
Lagged Dependent Variable:
Notes:
Figures in parentheses are "T" statistics
2 Changes expressed as percentages (i.e. multiplied times 100)
20
FOOTNOTES
9. Actually the theory implies that the unemployment rate is a
function of the difference between the sctual and expected price
level. Assuming that agents know last period's price level, however, Ap(t) - Ap(t)e = (p(t) .... p(t-l» .... (pe(t)) - p(t-1)) =
pet) - pe(t), so (3) is consistent with the theory.
10.. This assumption was often implicit. That is. in simulations of
econometric models, the h(i) wereas.sumed invariant to the policy assumptions. This. methodology had been forcefully criticized
by Thomas Sargent and Neal Wallace ("Rational Expectations
and the Theory of Economic Policy", Journal of Monetary Economics, (2), i976, pp. i68-184).
11 .• Indeed, the theory is really a further dllvelopment of earlier
notions about how expectations Were fonned; Adaptive'expectations schemes wereoriginaHy introduced because they
seemed to provide a common-sense method for forecasting
economic variables. Rational expectations provides a more precise definition of what it means to forecast "sensiblY".
12. Several qualifications of this view are worth noting. First, a
basis for counter-cyclical policy exists if the government possesses superior information, that is, information not available to
the market. For example, suppose that the government could
withhold aggregate unemployment statistics from the market.
Then it could successfully carry out the counter-cyclical policy
summarized in equation (4) because individuals would not possess the data needed to forecast money growth. Proponents of
the combined rational-expectations and natural-rate theories
generally argue that the government should publish its information and allow individuals to decide how to respond to it. See
Robert Barro, op. cit., p. 2. Second. the rational-expectations
and natural-rate theories do not imply that government policy
has no impact on variations in unemployment, only that it has no
systematic impact. If the government policy is prone to errorthat is, if the policy produces unanticipated money-stock
changes-it will generally raise the variability of unemployment.
This is not usually regarded as a desirable objective.
13. Indeed, if commodity markets were efficient in the sense often used in stock-market literature, price-level changes would
be random so long as the long-run inflation rate were constant.
Under these circumstances, cyclical variations in nominal money
would lead to cyclical variations in real balances. For a review of
theories of contract pricing and other "rigidities". see Robert J.
Gordon, op. cit_, pp. 185-219. Richard J. Sweeney, "Efficient Information Processing in Output Markets: Tests & Implications,"
Economic Inquiry, July 1978 provides theoretical and empirical
arguments for commodity-market efficiency.
14. The reason is that changes in real balances affect the utility
yield of existing holdings. For example. in William Brock's perfect-foresight model, ("Money and Growth: the Case of Long
Run Perfect Foresight", International Economic Review, October 1974, pp. 750-777), a pre-announced increase in future money growth leads to an immediate increase in prices and will
generally alter consumption if goods can be stored.
15. For example, in the reconstructed Bank of Japan macromodel, the availability of credit to the corporate sector is an explanatory variable in relations determining inventory and private
fixed investment; real liquid deposits of the private household
sector are used in the equations for consumption as well. See H.
EguChi and S. Tanigawa. "The Bank of Japan Econometric Model-AProgress Report on its Reconstruction" in Proceedings
of the Second Pacific Basin Central Bank Conference on
Econometric Modeling, June 1976.
16.Deficit finance became legally permitted in 1965. Ackley
and Ishi (1976) have argued that even after this date, fiscal policy was primarily directed at objectives other than counter-cycli-
1; Fora brief description of the influence on U.S. policy, see
Robert J. Gordon, "Recent Developments in the Theory oflnflation sndUnemployment," Journal of Monetary Economics, (2).
1976, p. 190. David Laidler and Michael Parkin, "Inflation, a Survey", Economic Journal, December 1975, pp. 741-809 and
Rutledge (1975) provide more detailed surveys of the evolution
oftneoriesabout the Phillips Curve and about monetary policy
and economic activity.
2. In the model in the tllxt, a, snda, must be chosen so that
unemployment· is stationary. Ingenerafthe greater the response
of current unemployment to its past, the greater the severity and
the longer the duration of business cycles.
3. The "Phillips Curve" became a significant influence on economic policy with the publication of A. W. Phillips, "The Relation
Between Unemployment aodthe Ratllof Chahgeo! Money
Waglls, 1862-1957," Economics, November 1958, pp. 283299. This deSCribes an apparently stable relation between moneywage changes and unemployment in the United Kingdom over
the period 1862-1957.
4. Policy prescriptions to exploit the Phillips Curve were generally described in somewhat different terms. Price changes were
assumed to be positively related to excess demand, proxied by
the unemployment rate. The implication was that by raising aggregate demand, through either fiscal or monetary policy, unemployment could be reduced while inflation would be raised.
5. Strictly speaking, the neutrality proposition refers only to unsustained changes in the level of money, not to changes in the
rate of inflation. Variations in the inflation rate alter the real return to money balances and may, as a result, affect the demand
for capital; if so, ihe natural rate of unemployment will not be
invariant to the long-run rate of money growth. The proposition
that the natural rate is unaffected by the rate of inflation is sometimes referred to as "super-neutrality." Natural-rate theorists
assert that this is a valid approximation of actual behavior.
6. The first complete description of the elements of the naturalrate hypothesis was given by Milton Friedman ("The Role of
Monetary Policy," American Economic Review, May 1968).
Friedman defined the natural rate as that which would be determined in a general-equilibrium system of excess-demand relations for commodities and factors; these relations were
assumed to be functions of relative prices and invariant to movements in the general price level. Variations in unemployment
about the natural rate were assumed to result (in part) from unanticipated movements in the price level. Strictly speaking, his
account implied only that a permanent rise in inflation would
have no long-run impact on unemployment; it did not rule out the
possibility that an accelerating rate might have an impact.
7. This was one of the elements of Friedman's original statement of the natural-rate hypothesis. It was also central to attempts by Phelps and others to develop a micro-economic
theory of the temporary Phillips Curve based on incomplete information and costly search in the labor market. See E. Phelps
(ed.), The Microeconomlc Foundations of Employment and
Inflation Theory. The reader will have noticed that the naturalrate hypothesis and formulations of the natural-rate theory are
distinguished in the text. The reason is that many economists
who accept the proposition that the Phillips Curve is vertical in
the long run do not accept all elements of what are commonly
known as natural-rate theories. In this sense Friedman stated
both the natural·rate hypothesis and a theory of the natural rate,
the latter being more restrictive.
8. This is essentially the account given by Robert Barro in "Rational Expectations and the Role of Monetary Policy", Journal
of Monetary Economics, (2), 1976. pp. 1-33.
21
cal policy (p. 231).
17.· See, for example, Keran (1970) pp. 174-175.ln addition, the
QECD (1972), pp. 1-32 and Ackley and Ishi (1970), pp. 196205, provide detailed descriptions of the institutional setting of
Japanese monetarypoliGY.
18. According to the OECD, for example, "The Bank of Japan
influenced the banks' lending attitude, buttressed by its ability to
control (ration the volume and raise the cost of) its own credit,
the predominant source Of reserve money in Japan. The restraint
on the <availability of domelltic bank credit was subsequently
conlloliQateQby direct quantitative controls on the major banks'
lending ... Adeceierationof bank-credit expansion aiways set in
immediately after the first restrictive action of the central bank:
In each case, the degree of this slowdown seems to have been
generally in linewith that aimed at by the authorities" (p. 9). See
also Ackley and Ishi, pp. 204-205. Keran (176-177) views "windowguidance"as primarily a device designed to share business
among banks, rather than as a device to control the aggregate
level of credit.
19. The precilleperiods in the text refer to money-growth rates.
The periods of "severe restraint" identified by the OECD (pp.
87 ~90)arequite similar although, because reserve losses
themselves tended to reduce money expansion, they tended to
lag the slowdown by about a quarter.
20. The relation between reserve losses and M, growth has
been extensively documented by Keran, Ackley and Ishi, and the
OECD. Keran develops a compact model of the relation between
economic activity and reserve changes on the one hand and between activity and monetary policy on the other. The OECD
study, pp. 51-58 and Appendix III, discusses the impact of monetary policy on investment; see also Ackley and Ishi, pp. 193195.
21. Total Japanese reserves more than tripled over 1971, from
$4.8 billion at the end of 1970 to $15.4 billion at the end of 1971.
Largely as a result, Japanese M, rose by nearly 30 percent during 1971. Keran (p. 189) describes the severe reserve constraint faced by Japan during the 1960's.
22. See Keran; the OECD; Robert Gordon, "World Inflation and
MOnetary Accommodation in Eight Countries", Brookings Papers on Economic Activity, 1977:2; and Leroy D. Laney and
Thomas Willett, "The Causes of Global Monetary Expansion",
unpublished, August 1977. The first three use M, data in analyzing the determinants of money growth and the latter analyze
both M, and M 2 • The Bank of Japan ("Role of the Money Supply in
the Japanese Economy", Special Paper #60, October 1975) argues that from 1965 on, M 2 changes were somewhat more closely related to variations in prices and real income, but that prior to
1965, M, changes were generally slightly more correlated with
these variables. For reasons explained later, the effects of money growth on activity are evaluated using seasonally adjusted
data. Tlterefore, the M, and reserve series used in the money
prediGtion equation were also seasonally adjusted; the procedure used was the multiplicative version of the Commerce Department's X-ll applied to the level of each series.
23. The calculation in the text was made using 1965 year-end
values of gold and foreign-exchange reserves and the 1965 yen
value of the dollar (360.8). As Keran (p. 192) has shown, the
response of M, to reserve changes tended to vary with the composition of the Japanese government.
24. A correction for first-order serial correlation of the disturbance was also applied. Two other features of this procedure
should be noted. First, seasonally·adjusted data are used for
the activity variables and for money growth. Standard seasonaladjustment procedures may distort the temporal relations
among economic variables. Seasonally adjusted data were used
because no unadjusted figures for real GNP were available.
N<:methelesll, results using such data must be interpreted with
caution. However, it was possible to estimate a relation similar
tothatinTablell using unadjusted money data (with seasonal
dummies)anQ<tousethis to evaluate the impact of money
growthonunadjusteQ inQulltrialproduction. The results obtained
ar~,ifanything.stronQerthan those reported in the text. Sec'
ond, the procedure used is strictty valid only if current changes
inaCtiVity are assumed to have no impact on current changell in
M,.This d()esnot seem implausible in view of the relatively close
control normally maintained by the authorities over domestiG
money.However, ifitis not true, the estimates of the impact of
currentmoney growth on activity will be biased. Again, however,
the results arllnot substantially altered if the current money
growth terms are omitted.
25. This \Nillalso be true if all the coefficients of the moneygrowth COmponents are zero. The argument in the text indicates
whY the estimated coefficients must change sign at least once if
thenatural'ratll hypothesis is to hold.
26. When the natural-rate hypothesis is not imposed on the estimates,the hypotheses that anticipated and unanticipated money·growth components do not influence industrial production can
eaCh berejeGted. The hypothesis that predicted money has no
impact on real GNP cannot be rejected; however, the "F" statistic iSGlose to the critical 5-percent value and is significant at the
to-percent leyel.
27. This does not, of course, mean that policy actually stabilized Japan's real output. To establish this, the changes in outpUt .that would have occurred had the policy not been followed
would haye to be compared with the actual path of output, a task
beyond the scope of this paper. Ackley and Ishi argue that the
authorities may have increased fluctuations in activity in an attemptlo avoid large reserve losses (pp. 170-171).
28. Kurt Dew has pointed out the contrasting structure of U.S.
and Japanese monetary policy. His article "Practical Monetarism and the Stock Market" in the Spring 1978 issue of this Review de.scribes the shift in U.S. monetary policy beginning,
roughlY,after 1970. He finds that after 1970, unanticipated moneyinGreases in the U.S. tended to depress stock-market prices.
29. However, this argument is admittedly plausible only when (if
then) anticipated money growth influences real output. Suppose,
for example, that individuals' planned levels of spending depenQed upon their anticipated present and future levels of real
money balanGes. Imagine that money increases unexpectedly
anQ that prices respond to this increase very slowly. Then individuals' real balances may be expected to be above normal for
sometime. In Japan, however, the impact on real balances may
haye peen more temporary than in the U.S., so that real output
was affected for a shorter time. Obviously the validity of this
argument depends upon the response of prices to money increases. and on other factors. It also does not prOVide a satisfaGtory explanation of why the level of real output falls below
normal in the quarters following an unanticipated rise in M" nor
does it explain why anticipated money had a stronger and more
persistent impact than in the U.S.
30. Several other relations were estimated which are 'not reporteQ here. First, similar equations were tried for changes in
the ratio Of private non·residential fixed investment to GNP, and
in the ratio of inventory investmllnt to GNP (both seasonally adjusted). The results were very mixed; in general, when the long·
run natural·ratehypothesis is imposed, the hypothesis that anticipateQ monllY has no impact cannot be rejected. As noted in a
previous tootnote, the hypothesis was also tested using seasonally unadjusted M reserve data, and industrial production.
These results-which" are quite consistent with those reporteQ anQthe investment relations will be supplied upon request
to the author.
22
Michael Bazdarich*
This paper examines the inflation experience of
eight Pacific Basin countries-the United
States, Japan, Australia, South Korea, the Philippines, Malaysia, Taiwan, and Singapore--over
the 1957-77 period. We will attempt to identify
the causes of persistent inflation in each of these
countries.
Note that we concentrate on explaining persistent inflation rather than simply short-term
movements in particular prices. Over the last
twelve years in the United States, and for a good
deal longer in many other countries, price levels
have climbed steadily, and at average rates that
are high by historical standards. Furthermore,
there is no sign of a slowdown in this phenomenon. World inflation has not been a temporary
outbreak, confined to a few commodity prices,
but a continuing process affecting all prices.
In the next section, we will argue that inflation
can continue only if there are continuing increases in the money supply. Non-monetary factors can cause temporary movements in the price
level, but if these are responsible for prolonged
inflation, they must in some sense cause shifts in
the rate of monetary expansion. According to our
line of reasoning, then, identifying the reasons
for accelerated money growth means identifying
the reasons for increased inflation.
This approach is vital in formulating an antiinflation policy. For if monetary expansion, and
so inflation, has been an autonomous policy decision, then only tighter monetary policy will be
able to stop inflation. If this were the case, price
and wage hikes would moderate once monetary
policy moderated. Another possibility, however,
might be that monetary policy has been forced to
accommodate large price or wage increases, or
other disturbances. In this case, monetary tightening would subject the economy to the effects of
these disruptions, with little near-term effect on
inflation. A more effective policy in this case
would be direct government action to slow price
increases. The choice of policy therefore depends
on whether monetary expansion is seen as the
cause or effect of price changes.
This paper will investigate four factors which
are said to affect money-supply growth: increasing wage demands, the OPEC oil price hike of
1973, government deficit spending, and the international transmission of inflation from abroad.
We will consider whether these factors have indeed systematically caused money growth and
inflation. The next section briefly discusses an
economic theory of inflation which links the
money supply and the price level. Section II presents Pacific Basin evidence for this link. Section
III investigates the effects of the above four factors on money-supply growth, and Section IV
provides a brief summary and discussion of these
results.
I. Money and Inflation in Theory
even decline. These varying rates of change reflect the impact of such factors as changes in
tastes, shifts of labor and capital among industries, and introduction of new productive techniques. While these phenomena can explain
movements in some prices relative to others during an inflation, they cannot explain the inflation
itself, the upward tendency in all prices.
Inflation is an increase in the money price of
virtually all goods. Still, in any inflationary situation the prices of some goods will rise faster
than others, and the prices of still others may
*Associate Economist, Federal Reserve Bank of San Francisco. Benny Yu and Norman Carleton provided research assistance for this paper.
23
pounds, and they will be satisfied with this tradeoff only if tomatoes yield twice the revenue of
corn. <Similarly, at this price consumers know
that for every extra pound of tomatoes they purchase, they can purchase two less pounds of corn,
and so they will adjust their consumption habits
until they are satisfied with this trade-off.
At tile same time, economic agents hold money
because of the various conveniences it allows.
They cannot increase consumption of both goods
without decreasing their holdings of cash, and so
decreasing their enjoyment of these conveniences, nor can they increase holdings of money
without decreasing their consumption of goods.
The money price of goods, then, indicates the
purchasing power of money and so will tend to
equal the value to agents of holding cash balances.
As we have said, outputs of corn and tomatoes
will reflect consumers' desired consumption mix
given the 2-to-l trade between commodities. If
the supply of tomatoes is increased above the
usual level, the price of tomatoes will have to fall
before consumers will be willing to purchase the
increased amount. Furthermore, the output of
tomatoes can be so increased only if that of corn
falls. Though tomatoes are more plentiful than
before, corn is more scarce, and consumers will
be willing to pay higher prices to obtain these
smaller amounts of corn. As the price of tomatoes falls, that of corn rises. Therefore the average price level, and so the purchasing power of
money, need not change.
If production conditions and consumer tastes
have not changed, prices and outputs will eventually move back to their old levels. However, even
in the short run, when outputs are varying, the
price level need not change since decreased tomato prices are offset by increased corn prices.
Again, this is because output of one good can be
changed only by changing output of the other
good in the opposite direction.
This is not true of the money supply. For example, it takes no diversion of resources to change
the denominations of currency. 1 Yet such redessignation will permanently change the supply of
dollars. With an increased supply of dollars,
money is less scarce at old prices, and consumers
will attempt to spend some of their increased
Economic theory distinguishes between factors
such as these which affect relative prices, and
those which affect the general price level. We
can outline the reasoning behind this distinction,
and give some flavor of the effect of money on
prices, by discussing price determination in a
very simple economy.
Consider an economy consisting of two commodities, com and tomatoes, and a fixed amount
of cash. Assume that land and water are plentiful
enough so that labor is the only scarce factor in
producing these commodities. Also, assume that
one-hour of labor will produce two pounds of
corn but only one pound of tomatoes.
In such an economy, possible outputs of the
two commodities can be detailed by a production
possibility curve as shown in Figure 1. This curve
shows the maximum amount of corn that can be
produced if tomato production is at a given level,
and vice versa. The negative slope of this curve
reflects the fact that tomato output can be increased only by drawing labor away from corn
production, and so reducing corn output. Also,
the slope of this curve is -2, which reflects the
fact that one man-hour produces twice as many
pounds of corn as of tomatoes.
Prices and outputs in the economy will reflect
consumer tastes as well as these production conditions, with the end result that tomato prices
will tend to be twice those of corn. Farmers know
that they can increase tomato output by one
pound only by decreasing corn output by two
Chart 1
Production Possibility Curve
Output
of Corn
P05;sible Production
Combinations
.. -2
Output of Tomatoes
24
resources and expenditures from one good to another, ultimately causing some money prices to
rise and others to fall. Only increases in total asset holdings can augment spending on all goods.
Furthermore, only increases in the money supply
can permanently augment spending without augmenting productive capacity.
Certain restrictive assumptions are made in
our model. For example, it ignores changes in the
capital stock and the supply of labor, or technological advances, which could change the "output" line in Figure I. Also, changes in money
demand and government policy are abstracted
from. Such factors can cause short-term disturbances in the money-price relationship. However,
as suggested in the model, continuing inflation
must be accompanied by continuing growth of
the money supply. Furthermore, changes in the
money-supply growth rate will lead to changes in
the rate of inflation.
holdings by increasing purchases of commodities. This increased demand will bid up the
prices of both goods, and so the price level will
rise. Dollars are more plentiful, and thus the value or purchasing power of each dollar has fallen.
In the first example, corn becomes more scarce
relative to tomatoes, but goods do not become
more scarce relative to money, since labor shifts
from producing one good to producing the other.
Therefore the price level, which is the average
money price of all goods, need not change. In the
second example, demand and supply do not shift
from one good to the other. Rather, the larger
money supply increases the demand for both
goods. This makes both more scarce relative to
money, and the price level rises accordingly.
We have developed this analysis in a simple
two-good economy, but the same basic points
hold in the real world for any type of disturbance.
Changes in tastes, techniques, and wages switch
II. Money and Inflation in Fact
included in order to detrend the series, and so reduce the probability of finding a relation between
two variables which are not truly causally related, but which merely move up or down together
over time. 4 (See the Appendix for further details
on the Granger technique).
In the present context, the Granger causality
technique specifies estimating the following
equations:
The Pacific Basin countries have experienced
prolonged inflation over the last two decades.
Therefore, their experiences should provide some
evidence of the link between money growth and
inflation.
The correlation between the average rates of
inflation and money growth across countries is
.841 in the 1957-67 period (Table lA) and .654
in the 1967-77 period (Table 1B)2. The former
statistic is significant at the 1 percent level, while
the latter is significant at the 5 percent level. In
both sub-periods, then, there is statistically significant evidence of a relation between a country's rate of money supply growth and its
inflation rate. Yet while the data show a strong
relationship between inflation and money growth
across countries, they do not indicate the
strength of this relation within any given country. Nor do they determine whether money
growth caused prices to rise, or vice versa.
Granger causality tests provide one way of testing for the direction of such causal effects between two variables. 3 This technique is used in
most of the empirical analysis in this paper. It
involves regressing one variable on its own past
values and the past values of the other variable.
The lagged values of "dependent" variable are
8
8
(CPO t = a +. L: {Jj (MS)t-j+' L: ')'j (CPI)t-j +. Et,
j=1
j=1
(I)
and
8
8
(MS)t= a+' L: {Jj (CPI)t-j+L: ')'j (MS)t-j+' Et,
j=1
J=1
(2)
where (CPIh is the CPI inflation rate in quarter
t, (MSh is the money supply growth rate at
quarter t, Et is a random disturbance term, and
the a's, {J's, and ')"s are coefficients to be estimated. Money growth can then be said to "cause"
inflation if the (3-coefficients in equation (1) are
significantly different from zero and generally
25
Table 1
Inflation and Money Supply Growth
TABLE lB
TABLE lA
1958.1-1967.IV
(2)
(1)
(2)
Average CPI
Average Money
Average CPI
Average Money
Inflation
Supply Growth
Inflation
Supply Growth
Rate (%)'
Rate (%)2
Rate (%)'
Rate (%)2
(1)
Korea
Taiwan
Japan
Philippines
Australia
United States
Malaysia
1968.1-1977.IV
12.03
23.01
4.62
19.25
4.34
16.82
4.17
8.57
2.32
2.77
3.44
2.19
1.75
0.55
Correlations
between columns
(I) and (2)
Korea
Philippines
Japan
Australia
Taiwan
United States
Singapore
Malaysia
.841 ..,
13.29
33.26
10.78
16.71
9.28
16.35
8.81
9.11
8.62
22.72
6.22
5.96
5.34
16.01
4.52
14.89
.654"
" Significant at 5 percent level.
'''Significant at I percent level.
(I) Geometric average rate of change in consumer price index.
(2) Geometric average rate of change in money supply.
Source: International Financial Statistics, International Monetary Fund.
and significantly different from zero at a much
higher confidence level than the 11 vectors in
equation (2). Furthermore, the long-run effects
of money on prices are generally insignificantly
different from one, as the quantity theory of
money would suggest. 8 (Column 4 of Table 2)
For most countries, then, money-supply growth
apparently has had a systematic effect on inflation, with little or no reverse effect.
Two exceptions to these results are Japan and
Korea. For Japan, the F-test for equation (1) is
barely significant at the 10 percent level, while
that for equation (2) is significant at the 5 percent level, and remains so under reformulations
of this equation. 9 In other words, there is twoway "feedback" between money and prices.
However, the values in equation (2) are generally
negative. In this context, the results suggest that
monetary policy in Japan reacted strongly to
counter the effects of temporary price movements,. rather than to accommodate them. lO
For Korea, the F-statistic for equation (1) is
significant at the 5 percent level, yet the cumulative effect of a change in money growth on the
positive. Such a result would concur with our
conclusions in the preceding analytical section.
On the other hand, if disturbances in the real
economy caused prices to rise, and eventually
forced the money supply to increase, money
growth would be "caused" by short-term inflation. In this case, the l1-coefficients in equation
(2) should be generally positive, so that inflation
would "cause" money growth. Since equation (2)
measures the response of the money supply to
price-level disturbances, its estimation provides
our first evidence on monetary accommodation
of disturbances in the real economy.5
Equations (1) and (2) were estimated using unadjusted quarterly data with seasonal dummies
for the period 1959:1 to 1977:IV6 (Tables 2 and
3). The hypothesis that 111 = ... = 118 = 0 in equations (1) and (2) can be tested by use of an Fstatistic? (Column 8 of those tables). Significant
F-values of these statistics indicate the respective
coefficients are significantly different from zero.
These results generally suggest causality running from money growth to inflation. That is, the
11 vectors in equation (1) are generally positive
26
Table 2
Effect of lagged Money Supply Growth on Inflation
8
8
Estimates of CP1t = a + :i:{3j {MS)t-j + :i:i'j (CPI)t-j + Et'
1
1
(4)
(6)
Long Run
Effect of
MS on CPI'
(7)
(8)
R'
DurbinWatson
Statistic
Australia .........
-0.17%
0.36
0.63
0.98
(-0.09)
0.68
1.97
3.09%
3.52***
Japan ............
-0.41%
0.20
0.60
0.35
1.91
5.03%
1.77*
Korea ............
7.69%
0.04
0.33
0.50
(-0.84)
0.07
(-1.80)*
0.20
1.99
12.10%
Malaysia . . . . . . . . .
-0.01%
0.14
0.59
0.34
(-2.28)**
0.66
1.90
3.48%
3.42***
Philippines ........
-1.39%
0.70
0.10
0.79
(-1.06)
0.51
2.01
7.61%
2.57**
Singapore2 ........
-7.95%
0.70
0.62
1.81
(1.24)
0.71
2.28
6.40%
2.71**
Taiwan ...........
-8.48%
0.66
0.37
1.04
(0.07)
0.22
1.98
13.82%
1.94*
United States .....
-0.15%
0.40
0.68
1.27
(1.05)
0.81
1.97
1.30%
(1)
(2)
(3)
a'
:i:{3j
:i:i'j
(5)
Standard F Statistic
Error of
for
Equation3 {3,= ... ={3.=O
2.93***
* Indicates significance at 10% level
** Indicates significance at 5% level
"*Indicates significance at I% level
'Equation estimated with seasonal dummies, except in the case of Taiwan, for which the seasonal dummies increased the standard error of the equation. Period covered is 1959:1 to 1977:IV.
2Period covered is 1966:1 to 1977:IV. Because of the lower number of observations, the data were "mined" by taking the four
most significant {3 and four most significant i' coefficients and re-estimating.
3Statistics are in annual rate-of-change terms.
'Defined as Column 2 divided by one minus Column 3. (See Appendix for an explanation). Figures in parentheses are the tstatistics for the hypothesis that this long-run effect equals one.
inflation rate is very small. This is surprising for
a country which has averaged 12 percent inflation and 27 percent money growth annually over
the past twenty years. Meanwhile, the effect of
inflation on money growth is positive and marginally significant, indicating some monetary accommodation of price increase.
Even in these cases, there is some evidence of
the effects discussed previously, and there are
several possible explanations for the lack of
stronger results.' 1 Still, the effect of money
growth on inflation appears surprisingly weak in
Japan and Korea.
With these two exceptions, the results support
our hypothesis that money-supply growth rates
determine the underlying or continuing rate of
inflation. The question then in explaining inflation becomes what caused monetary policy to act
the way it did.
m. Evidence on Monetary Accommodation
What factors might stimulate money-supply
growth and therefore lead to more rapid infla-
tion? Certain disruptive shocks to the economy
could perhaps have this effect, such as large com27
Table 3
Effect of lagged Inflation on Money Growth
Estimates of
8
(MS)t = a
+ :Zl3j
1
8
(CPl)t-j + :Z'Yj (MS)t-j
1
+ ft'
(6)
(4)
L009 flun
Australia
Japan
Korea··
Malaysia
Philippines
Singapore2
Taiwan
United States
.
.
.
.
.
.
.
.
(1)
(2)
(3)
a3
~l3j
~'Yj
0.28
-0.66
0.53
0.34
0.56
-0.14
-0.11
0.37
0.48
0.04
0.32
0.07
-0.68
-0.22
0.22
0.51
2.75%
14.67%
37.64%
5.20%
7.05%
29.00%
27.65%
2.03%
Effect of
MS on CPl·
(5)
0.45
-1.29
0.79
0.91
0.37
0.26
0.53
0.55
0.59
0.95
0.55
0.51
0.60
-0.08
-0.09
0.44
.......
R2
(7)
(8)
Durbin- Standard F Statistic
Error of
for
Watson
Statistic Equation 3 I3,= ... =@.=o
1.93
1.93
1.76
2.00
1.89
1.98
1.95
2.03
8.69%
8.67%
25.85%
15.94%
12.59%
12.19%
19.22%
4.81%
0.59
2.47**
2.05*
1.22
1.77*
1.01
1.16
1.17
* Indicates significance at 10 percent level.
** Indicates significance at 5 percent level.
'Equation estimated with seasonal dummies over the data period 1959:1 to 1977:IV.
2Period covered is 1966:1 to 1977:IV. (See footnote 2, Table 2.)
3Statistics expressed in annual rate-of-change terms.
'See Footnote 4, Table 2.
modity-price or wage increases. These increases
act primarily on relative prices and the distribution of resources across industries, with little
long-run effect on the price level. However, in the
short run, resources can be slow to move among
industries, and prices can be slow to adjust to reductions in demand. Therefore, the disruptive effects can cause temporary-but nevertheless
painful-reductions in employment and output.
To counter these effects, monetary authorities
might seek a more expansionary monetary policy. In the long run this would lead to inflation,
but the short-run gains could well make such
moves desirable. 12
Large commodity price increases, such as
OPEC's quadrupling of oil prices in 1973, can
also seriously strain an economy and so pressure
monetary policy to provide accommodation.
Similarly, large government deficits might be
partially funded through money creation, in order to avoid disruptive changes in interest rates
due to government borrowing needs.
Imported inflation could generate still another
form of pressure. An expansionary monetary
policy abroad, while causing foreign inflation,
would also tend to stimulate domestic exports,
and thus push the domestic-payments account
into surplus. In the absence of complete exchange-rate adjustment, inflows of foreign assets
due to the surplus might cause international reserves, and eventually the money supply, to increase domestically. Capital inflows and
inflation would then continue until domestic
prices were back in balance with prices of the
country initially responsible for the inflation.
Proponents of this view have attributed the world
inflation and monetary expansion of the late 60's
and early 70's to expansionary U.S. government
policy during the Vietnam War era.
These four possible sources of pressure-wage
push, commodity price increases, deficit spending, and foreign inflation-should have had a
systematic effect on money growth rates if they
were responsible for continued inflation. As be-
28
change of the money supply, and other variables
are the parameters ot the equation. If wage increases have "pushed" the money supply, then
the (3 coefficients in equation (4) should be significantly different from zero and generally positive. If wage increases have been a response to
monetary inflation, then the {3 coefficients in
equation (3) should be significant and generally
positive.
Equations (3) and (4) were estimated using
quarterly data and seasonal dummies for the five
countries for which data were available: Australia,Japan, Korea, the Philippines, and the U.S.
The results of these estimations are summarized
in Table 4 by the long-run effects of the independent variable, as defined in the Appendix, and
the F~statistic for the hypothesis that {31 = f32 =
... = f38 = 0 in either equation. Since available
data covered different periods, critical F-values
vary across countries. The 5 percent critical values of the F-statistic for each country are shown
in parentheses following the name of each country.
Only in the case of Japan is there significant
causality at the 5 percent level for equation (4).
In that country, prior wage changes exert a
strong but negative effect on money growth.
fore, we can use Granger causality tests to determine the effect these factors have had on moneysupply growth.
A. Wage-push
If increasing wage settlements have consistently contributed to persistent inflation by forcing
faster growth, then the rate of change of wages
should statistically "cause" money growth, in
much the same way that money growth was seen
to cause inflation in the preceding section. On the
other hand, if wage settlements have been merely
a reaction to already existing inflation, then
money growth should statistically "cause" wage
increases.
To resolve this question, we can estimate the
following models:
Wt
&
8
= IX + L:
{3j (MS)
t-j
+ t
1
'Yj (W)
t-j
+ flo
1
(3)
and
MS t
8
= IX + L:
{3j (W)t-j
8
+ L:
1
'Yj (MS)t-j
+ ft
1
(4)
where \\t is the percentage rate of changes in
wages at time t, MS t is the percentage rate of
Table 4
Relation Between Money Growth
and Wage Increases
(1)
5%
Critical
F-Statistic
Australia
Japan
Korea
Philippines
United States
.
.
.
.
.
(2.1 9)
(2.11)
(2.95)
(2.1 9)
(2.1 I)
(3)
(2)
(4)
F-Statistic for Long-run Effect
Long-run Effect Hypothesis that of (MS) on (W)
ofW on MS
in
(3,=(32=' .. =(3j=O
in Equation (4)' in Equation (4) Equation (3)'
0.50
-12.03
-0.19
-0.10
.50
1.12
2.64**
2.35
.34
1.46
0.79
2.31
-6.38
-0.02
1.27
(5)
F-Statlstic for
Hypothesis that
(3,=(32=' .. (3,=0
in Equation (3)
1.33
2.12**
1.86
.75
1.91*
* Significant at 10 percent level.
** Significant at 5 percent level.
1
This statistic is defined as ~(3jl (1- ~'Yj) for the appropriate regression equation. See Appendix for derivation.
Note: Periods covered are 1961:III to 1977:IV for Australia, 1957:1 to 1977:1V for Japan, 1968:1 to 1977:IV for Korea,
1961 :IV to 1977:IV for the Philippines, and 1957:1 to I977:IV for the United States. Wage data are weekly earnings for
Australia, monthly earnings for Japan and Korea, daily wage rate for the Philippines, and hourly earnings for the United
States.
29
Again, it appears that policy reacts strongly in
Japan to counter inflationary disturbances, rather than to accommodate them, as was suggested
in the preceding section. In terms of the wage
equation (3), the effect of lagged money growth
on wages is significant, indicating mutual interdependence between Japanese money growth
and wages.
Because of its nature as a one-time shock, this
phenomenon was examined with somewhat different techniques than those used elsewhere.
Equations (1) and (2) were re-estimated including a dummy variable for the eight quarters following the oil price increase. 14 The "oil dummy"
inserted in equation (l) shows the amount of inflation thads over and above that which could be
predicted from the past behavior of money and
prices. Similarly, the dummy in equation (2)
shows the amount of money growth in excess of
that predictable from the past behavior of money
and. prices.
For most countries, inflation was significantly
higher following the oil shock than previous monetary growth could explain. (Table 5, Column 1)
While the "inflation-effect" dummies are generally positive and significant, this is not true of the
"money growth" dummies (Column 2). For no
country is this dummy variable positive and significant; thus, the oil price hike apparently was
not a source of significant monetary accommodation. Rather, the results are consistent with the
view that the oil price hike was primarily a relative price change with only temporary effects on
inflation.
For the other countries, none of the results are
statistically significant. The F-statistic for the
United States for equation (3) is nearly significant at the 5 percent level, and is larger than that
for equation (4). There no U.S. evidence of a
positive causal effect from wages to money. Elsewhere, the smaller number of observations tends
to preclude a powerful test of the hypotheses.
In order to correct for this, the data were
"mined" by taking the four most significant lags
for each set of variables in equations (3) and (4)
and reestimating the equations. When this was
done for Australia and Korea, the fJ values for
equation (4) remained insignificant and negative, while those for equation (3) were significant
at the 5 percent level and nearly so at the 1 percent level. 13 For the Philippines, the coefficients
in both equations (3) and (4) became "significant" and positive, so that only this Philippines
case provides any evidence of a systematic positive effect from wages to money. In general, no
hard evidence was found of a systematic accommodation of wage-push factors-of a positive
one-way effect from wage growth to money.
C. Deficit financing-inflation tax
Deficit spending is frequently seen as one way
in which the government causes inflation. Governments in underdeveloped countries are typically said to finance their expenditures by
printing money, and so taxing through inflation,
rather than by raising taxes directly. In developed countries, there is also political pressure to
avoid tax hikes, but, as discussed earlier, deficits
are most often blamed for inflation because the
money supply is increased to prevent rising interest rates. If either of these descriptions are accurate, large government deficits should cause
accelerations in money growth. Furthermore,
there need be no causal effect running from money to deficits.
On the other hand, one might argue that deficits and money growth are inversely related. This
could occur if monetary policy balanced or countered government deficits in a "fiscal-monetary
mix". This could seem to imply two-way causality or feedback between money and deficits. Al-
B. Oil price hike
The OPEC oil price increase provides a prominent example of the disruptive effects of commodity price changes on an economy. It is widely
recognized that this factor exacerbated world inflation in the 1974-75 period-yet once again,
the oil shock can be said to have caused continuing inflation only if money-supply growth accelerated to accommodate these effects. Furthermore, the United States and most other Pacific Basin countries experienced an acceleration
in money-supply growth that peaked some four
quarters before the oil price increase. It remains
to be seen, then, whether the oil price hike contributed to subsequent inflation, or was itself (at
least partly) a response to previous inflationary
money-growth.
30
Table 5
Effects of Oil Price Hike on Inflation and Money Growth
On Inflation'
Australia
.
Japan
.
Korea
.
Malaysia
.
Philippines
.
Singapore
.
Taiwan
.
United States
.
6.0%
(3.2)***
10.5%
(2.8)***
16.6%
(3.2)***
-3.3%
(-1.2)
-0.4%
(-0.1)
10.7%
(0.3)
13.1%
(1.0)
2.1%
(2.3)**
On Money Growth'
6.8%
(1.2)
6.2%
(0.9)
11.4%
(1.0)
-23.1%
(-2.1)**
-1.0%
(-0.1)
-6.7%
(-0.2)
12.9%
(0.9)
-7.2%
(-2.2)**
** Significant at 5 percent level.
***Significant at I percent level.
Note: Column 1 represents "oil dummy" in equation (I) and column 2 represents "oil dummy" in equation (2).
't-statistic in parentheses.
that the {3 coefficients in (6) are positive and significant without specifying much about the {3 coefficient in (5). A fiscal-monetary mix argument
would suggest the (3 coefficients in both (5) and
(6) are predominantly negative and significant.
Finally, the argument about exogenous monetary policy affecting taxes and thus the deficit
would specify that (3 is negative and significant in
(5) while probably zero in (6).
Government-deficit data were available for
Australia, Japan, Korea, Philippines and the
United States. As Table 6 makes clear, only for
the U.s. is there any sign of a positive effect of
deficit spending on money growth. However, the
F-statistics for the U.s. are insignificant for both
equations (5) and (6). Allowing for shorter lags
from deficits to money improves the U.S. F-statistic somewhat, but it is still not significant.
Where the F-statistics are significant, they indicate a negative effect of the deficit on money
growth, which is apparently consistent with a
policy-mix argument. This is the case with Aus-
ternatively, if the money supply were exogenous,
but increased subsequent tax receipts by stimulating income growth, money growth would have
a negative effect (i.e., it would reduce the deficit)
with no reverse effect from deficits to money.
Once more, we can formalize these hypotheses
in terms of a simple causality model:
(DR)t
8
=a + L
{3j (MS)t-j
1
(5)
(MS)t
8
=a +t
1
{3j (DR)t-j
8
+L
')Ij
(MS)t-n
+ tt
1
(6)
where (DRh is the deficit-to-GNP ratio in quarter t, and other variables are as defined before.'s
Thus, the inflation-tax hypothesis would specify
31
tralia, Japan, and Korea. For the Philippines, the
signs of the coefficients and the magnitude of the
F-statistics are most consistent with the exogenous-money argument, although the small number of observations precludes any definite
conclusions. In summary, then, there is little evidence from. these five countries of a positive imPactof deficit financing on money growth, which
means that the inflation tax has not been consistently important in explaining inflation.
planatory variables. That is, the following equationswere estimated:
(MS)t
8
=a +L
~j (MSU)t-j
8
1
+L
'Yj (MS)t_j
+ ft
1
(7)
D. ·Imported inflation
Evenjf a country is not affected by domestic
wage increases or government deficits, developments of this type abroad can lead to inflows of
funds and domestic monetary expansion. Several
observers have cited this scenario in blaming
world inflation on the effects of American deficit
spending, transmitted abroad under a fixed exchange-rate system.'6 Once again, if such arguments are correct, foreign inflation or monetaryexpansion rates should affect domestic money
growth.
Rather than attempt to construct a relevant
"world inflation" or "world money supply" series,17 we tested these hypotheses using U.S.
money-supply growth and inflation rates as ex-
(8)
where (MSh is domestic money-supply growth
at t, (MSUh is U.S. money-supply growth at t,
and (CPIUh is U.s. inflation at 1.
Under the imported-inflation hypothesis, if
U.s. money-supply growth exerts immediate effects on domestic money, then the ~ values in
equation (7) should be positive and significantly
different from zero. However, because of the lags
from U.s. money to U.s. prices, and from U.S.
prices to domestic money, eight-quarter lags may
be insufficient to capture these effects. In this
case, the ~ values in equation (8) would be more
Table 6
Relation Between Deficits and Money Growth
Estimates of Equations (5) & (6)
(3)
(1)
5%
Critical
F-Stat.
Australia
Japan........
Korea
Philippines
United States
.
.
.
.
.
.
(2.36)
(2.11)
(2.18)
(3.44)
(2.11 )
(2)
(5)
F-Statlstlc
(4)
for Hypothesis that Long run-
F-Statlstic for
Hypothesis that
Long-run
Effect of
fJ,=fJ2=' . ·fJa=O
Effect of
fJ,=fJ2=' .. fJa=O
(DRlt on (MS)t' In Equation (6) (MS)t on (DRh' In Equation (5)
-0.05
-0.74
-0.11
-0.44
0.43
1.99*
2.33**
3.02***
0.54
1.61
-1.68
-1.85
3.64
-1.55
om
2.08 *
1.95*
0.64
1.83
1.63
* Significant at I o percent level.
** Significant at 5 percent level.
***Significant at I percent level.
Note: Periods covered are 1965:1 to 1977:IV for Australia, 1957:1 to I977:III for Japan, 1960:1 to 1976:IV for Korea, 1969:1 to
1977:IV for the Philippines, and 1957:1 to 1977:IV for the United States.
'See footnote I, Table 4.
32
dation.. It might be objected that the techniques
employed were biased toward finding no causality, since the tests involved the significance of a
whole>vector of coefficients. Yet it's not clear
how meaningful are one or two significant lagged
coefficients, since the theories do not suggest,
say, that wages affect money growth at the thirdanq sixth-quarter lag. Rather, the monetary-accomodation hypotheses suggest that certain factors have some effect on money growth. The Ftests employed here showed the general explanatory power of past values of changes in the "independent" variables, which seems to be the proper
way to test the accommodation hypotheses. Furthermore, mining the data by re-estimating the
equations with only the most significant lags did
not change our conclusions in most cases. 19
Finally, any objections that would be made to
the estimation procedure used here would apply
equally to the procedure used in the preceding
section. Yet that section generally supported our
analysis of the effect of money-supply growth on
inflation, while the present section showed very
few systematic effects of commonly discussed
"inflationary" disturbances on money growth.
likely to capture the effect, since they have
dropped one source of lag in the process.
Equations (7) and (8) were estimated with unadjusted quarterly data and seasonal dummies
over the period 1957:1 to 1977:IV for the seven
countries other than the U.S. in our study.18 Fstatistics were then computed for the hypotheses
that {31 = {32 = ... = {38 = 0 in these equations.
Table 7 suggests that U.S. price and money developments are not very helpful in explaining
money-supply growth in Pacific Basin countries.
While the {3 values are generally positive, for the
most part they are not statistically significant.
Therefore, they provide little indication of a
causal effect of U.S. inflation on domestic money
growth.
When longer lags were tried in equation (7),
they did not change the results. Also, when Japanese money growth was substituted for U.S.
money growth, no causal effects emerged.
American inflation did show an effect on Malaysian money growth, but it is not clear how much
meaning we can attach to this isolated case.
In summarizing, we have found little evidence
in this section of systematic monetary accommo-
IV. Summary and Conclusions
ascribed as underlying causes of inflation. The
evidence presented here suggests that such factors as wage demands, deficit spending, and imported inflation did not, individually, sys-
This study has found the existence of a fairly
strong "causal" relation between the money supply and prices, but little causal effect on moneysupply growth from the factors most commonly
Table 7
Effects of U.S. Money and Prices on Domestic Money
F-Statistics for Hypothesis that
in
Equation (7)
Australia
Japan
.
Korea
.
Malaysia
.
Philippines
.
Equation (8)
1.46
1.23
0.32
0.80
1.04
1.14
1.40
2.29**
1.40
0.43
Singapore.
0.83
0.37
Taiwan .....
1.67
0.82
** Significant at 5 percent level.
33
tematically affect the money supply in thecountries studied, and therefore cannot be considered
sources of continued inflation.
If none of these factors have been consistent
causes of inflation, why have the Pacific Basin
countries experienced monetary expansion and
inflation? One explanation that is consistent with
Our results (although obviously not proven) is
that monetary policy has been truly discretion-
ary, designed to manipulatethe ups and downs of
the business cycle. Unfortunately, a meaningful
test of this hypothesis would involve an analysis
ofpolicy objectives that is far outside the scope of
this paper. For now, we have found no evidence
that the money supply has been led to expand in
response to certain commonly-mentioned sources
ofinflationary pressure.
Appendix 20
This Appendix explains the methodology of
Granger causality used in most oftheempirical
results in the text. A general model that can be
written for two time series Xt and Ytis
Xt
Yt
00
=a
00
L
+
L
(3jYt-j +
o
L
+
'YjXt-j + EI
(AI)
17jYI-j + tit.
(A2)
1
00
=
where et, ft are white-noise random processes. In
this formulation all right-hand side variables are
independent of et. ft and so these equations can
be consistently estimated.
Furthermore, if the (3 vector in (A.l) is zero,
then the b vector in (A. I') is zero, while if ~ = 0
in (A.2), m = 0 in (A.2'). Thus, causality can be
tested by running equations (A.l') and (A2')
with suitably truncated lags. This is the procedure taken in the text.
The text estimates such equations in the form
8
L
~jXt-j +
o
1
where Et and Ut are white-noise processes. In this
model, Yt can be said to cause Xt if the (3 vector is
non-zero, since in this case the y series will affect
the determination of the Xt. Similarly, Xt causes
Yt if the ~ vector is non-zero.
However, consistent estimates of (A.l) and
(A.2) cannot be obtained since if {3o and ~o are
non-zero, estimation will be subject to simultaneous-equation bias. In order to correct for this
problem, we can substitute (AI) for Xt in (A.2),
and solve for Yt, and substitute (A2) for Yt in
(A. I), and then solve for Xt. This yields:
Xt
=a
8
L
+
8
bjYI_j +
1
=d + L
CjXt_j
+ el
(Al")
njYI_j
+ fl'
(A2")
1
8
YI
L
n
mjXI_j +
1
L
1
Now suppose bl = b2 = ... = bS = 0 in (A.l If).
Then this equation becomes
8
XI
=a +L
CjXI_j +
gt.
(A.3)
1
XI
a
= (l-{3o~o)
(l-{3o~o)
'Yj+{3oJLj
00
+ L1
+
1-IJO~O
R
00
=a +
{3j +{3017j
00
zr
+
L
XI_j
EI+{3o~t
00
bjYt-j
+L
1
It can then be shown that under this hypothesis,
if SSR u is the sum of squared residuals from the
estimation of (A. 1If), and if SSRc is that from
(A.3), then
Yt-j
CjXt-j
I -IJO~O
R
+ et.
(A.n
1
J
=
.
and
Yt
=
00
t
u
R
l-lJo~o
llj
+
+ ~o{3i
l-{3o~o
'C'
L..,
1
~j- +~o'Yj- XI_j
l-{3o~o
YI_j +
~I
(SSR c - SSR u ) /S
(SSR u ) / (n-17)
(A4)
00
+ L..,
~
is distributed F with Sand n-17 degrees of freedom, where n is the number of observations. S is
the number of constraints placed on the b vector
(bl = b2 = ... =bS = 0), and 17 is the number of
1
+ ~oEI
l-{3o~o
34
coefficients estimated in (A.l/1). If three seasonal
dummies were included, the 17 would change to
20.
The statistic defined in (A A) can thus be used
to test the hypothesis that bi = b2 = ... = bg =
O. An equivalent test holds for ml = m2 = ... =
m8 = 0 in (A.2/1).
In the equations in Section 3, for example, the
data run from 1957:1 to I977:IV, 84 quarters.
One observation is lost in computing percentage
changes, and 8 more are lost in lagging the righthand side variables. Thus, the equation is fitted
over the period I959:U to 1977:IV, a 75-quarter
period. Subtracting 17 coefficients and 3 seasonal dummies leaves 55 degrees of freedom in equations (l) and (2). The F-statistics in Section 3,
then, have 8 and 55 degrees of freedom. The degrees of freedom for the other tests follow similarly.
The long-run effect of Xt on Yt (or vice versa)
can be defined as the change in the "steadystate" value of Yt(Xt) due to a change in the
"steady state" value of Xt(Yt). In (A.2/1), if Xt is
held at a value indefinitely, then Yt will tend to
a value y such that
or
8
Lm'
1
J
d
y=
8
+ - -8- x
I~Lnj
I-Lnj
1
1
8
In other words,
L
1
8
mj/(l- Lnj)
1
is the change in the long-run value of Yt due to a
sustained change in Xt. A similar formula gives
the long-run effect of Yt on Xt. These formulae
are used in computing the long-run values used in
the text.
Finally, applying seasonal filters to seasonally
adjust the data before estimating equations
(A.I/I) and (A.2/1) can be shown to introduce
spurious causality. However, adding seasonal
dummies to these equations using unadjusted
data can be shown to subtract seasonal means
from the data without filtering it, and so without
distorting the causality relationships. The latter
procedure is therefore taken in the text.
x
FOOTNOTES
1. Obviously, money creation does divert some resources temporarily, but it does so in small amounts compared to the value
of the currency printed. Furthermore, a permanent increase in
the money supply can be accomplished by only a temporary use
of the printing presses.
Alternatively, continually increasing supplies of one good
would require continual drains of more and more resources away
from the other goods. However, the money supply can be continually increased using the same amounts of resources.
2. The money supply series used in these and the other tables
is that given in International Financial Statistics, as published
by the International Monetary Fund. This series differs very
slightly from the Federal Reserve's M, definition, but corresponds to Japanese M, as published by the Bank of Japan. Singapore came into existence in 1966 and so is excluded from
Table 1.
3. For a full exposition of this technique, see Christopher Sims,
"Money, Income, and Causality," American Economic Review,
September, 1972.
4. For example, there is no economic reason to suppose that,
say, the population and the price level should be causally related. Yet because both have increased over time, a regression of
the price level on population alone would almost surely show
significantly positive coefficients. These would reflect the spurious correlation in the trends of the two series. However, including lagged values of the price level in the regression would
capture the trend in the price level and therefore tend to eliminate the significance of the population coefficients.
If one variable truly causes another, then the former should be
able to explain changes in the latter's trend. The Granger technique seeks to determine whether this is the case.
5. Notice that the {J vector in (2) need not show a central bank's
reaction function to inflation. If the inflation were originally
caused by monetary expansion, and the central bank thus
reacts to the effects of its own prior actions, such behavior will
show up in the"y coefficients in equation (2). The (J coefficients in
(2) are more likely to show the monetary response to temporary
price disturbances.
6. For Taiwan, the seasonal dummies did not improve the fit of
equation (1). They were therefore not used in the result shown
for Taiwan in Table 3.
7. For an explanation of this test, see Franklin Fisher, "Test of
Equality between Sets of Coefficients in Linear Regressions,"
Section 3.1, Econometrica, March 1970.
8. This long-run effect is derived in the Appendix.
The Quantity Theory is the traditional theory of the effect of the
money supply on prices. For a review of it, see Millon Friedman,
"The Quantity Theory of Money: A Restatement," in his Studies
in the Quantity Theory of Money.
9. When the four most significant lags of each set of variables
are retained in Equations (1) and (2), and these equations are
re-estimated, the vectors in both equations become significant,
with the {J's in equation (2) still having negative sum.
When such reformulations were done for other countries, however, the one-way causality from money to prices became more
prominent. Japan appears to be the exception here.
Also, running equation (1) over subperiods of the 1957-77 pe·
riod tends to improve the fit of inflation regressed on money,
35
sugg/ilsting that ()hangesin coefficients over time were more important for Japan thartother countries.
10. These results are in accord with other studies which have
fO\lnda strong counter-inflationary bias in Japanese monetary
policy in order to maintain external balance. On this subject, see
Charles Pigoll'sarticle in this Review, as well as R. Komiya and
S. Suzuki, "Inflation in Japan," in Wqrld Inflation, L. Krause and
W. S;l.lant(eds.), Brookings Institution, 1977.
11.gnesuchexplanationis that money growth ratesandinflation diQ not vary much over the sample perioQ for these countries, so that equation (1) had lillie variation to measure. A
measure of the variation of a variable is the ratio of its standard
deviation to its average value. This ratio gives the variation in
the variable relative to trend. When this "detrended variation"
varjaple waScOmP\lt/ilQfor ~achcountry anQ. cqmpareQ tq the
siz~ofJhe F-statistic in Table 3 for that country, the resulting
Sp~arman rankcorrelalion cqefficient wasO.95,whichissignifi.
cantatthe 1 perc/ilntlevel, In qther wqrds. cquntries with significant variatiqn in rnqney-supply grq\yth rates tended to show
stronger effects of money growth on inflation.
We can rationalize this in terms of our theory as follows.
Chj;lngesin the mqney>growth rate alter the underlying rate of
inflj;ltion.1f a country's moneygro\yth rate does nqt vary much,
then its underlying rate of inflation will not vary much. The variations in the inflation rate that do occur will then be more likely
the temporary effects of relative price changes, or random factors, Wl)ich are less likely tq be affected by the money sUpply.
The effect of money-supply growth on inflation will then naturally
be statistically weaker in these cases, since money growth
rates are useful in explaining movements in inflation trends, and
few of these have occurreQ. It is instructiV/il to note that the tWq
countries with the .weakesteffect in Table 2, Japan and Taiwan,
also show the least variation in money-supply growth r/illative to
trend.
12. For another discussion of mqnetary accommodatiqn, and
fqr refer/ilnces to the various expanations of inflation, see Robert
J. Gqrdqn, "World Inflation and Monetary Accqmmodation in
Eight Countries," Brookings Papers on Economic Activity,
1977:2.
13. More precisely, these values would be significant at this
level if we had run the equation without use of prior information.
The fact that we used results from a previous estimate for this
sample reduces the significance of the results somewhat.
14. The oil embargo and quadrupling of prices occurred in the
4th quarter of 1973. The dummy period used was 1974:1 to
1975:IV.
15_ The ratio of deficit to GNP-rather than the deficit itselfwas used in order to induce stationerity in (Le., to detrend) the
government deficit series. The deficit series is in nominal terms
and so will be non-stationary during a period of rising prices. Dividing by nominal GNP will produce a variable which need not
automatically increase over time when prices do.
16. For references qn this argument, see Robert J. Gqrdqn, op_
cit.
17. This is nqt to minimize the relevance of such series. However, there is reason to believe that different countries are more
affected by some trading partners than others. However, a world
money-supply series gives a fixed weight to each country that
may be disproportionate to its effect on a particular Pacific Basin country.
While the U.S. money series does the same, by giving 100
percent to the U.S., it nevertheless helps us concentrate on the
hypothesis that U.S. money growth spawned world inflation, as
postulated in what Gordon calls the "international monetarist"
hypothesis.
18. The sample period for Singapore runs from 1966:1 to
1977:IV.
19. Nor do the causality conclusions change when inflation
rales are substituted for money-growth rates in equations (3i(8). The author will supply results of these other tests on request.
20. Larry Butler has developed this derivation of the causality
technique.
36
Hang-Sheng Cheng'
In i 974 and i 975, both Korea and Taiwan sustained unusually large current-account deficits
and borrowed heavily abroad. As their debts
mounted, the world banking community became
concerned over the risk of continued heavy lending to those countries. Yet by 1977, barely two
years later, both countries' balance of payments
showed dramatic improvements and the earlier
fears evaporated-indeed, international bankers
began to worry instead that these countries
would make early debt prepayments or refinance
on more favorable terms. This study examines
the factors accounting for Korea and Taiwan's
success in achieving such rapid adjustments in
their balance of payments.
During the two crucial years, 1974 and 1975,
the two countries apparently followed different
approaches toward balance-of-payments adjustment. Taiwan, on the one hand, pursued what
may be characterized as a classical "gold standard" approach. It maintained a fixed exchange
rate of its currency against the U.S. dollar, and
adjusted primarily through domestic deflation
and restrained growth of imports. Korea, on the
other hand, did not deflate; indeed, it achieved a
remarkably high economic growth rate in the
midst of a severe world-wide economic recession.
It devalued its currency in the face of domestic
price increases, and reduced its payments deficit
mainly through export expansion. Both countries
achieved payments adjustment, but the paths
were different.
These alternative paths of adjustment represent alternative policy responses to external disturbances. During recent years, the oil shock and
the world stagflation have brought about very
large trade deficits for many oil-importing countries. External borrowings have provided deficit
countries with the needed time to adjust their
production and consumption patterns, and thereby reduce their trade deficits. But each deficit
country that failed to make the necessary adjustment has had to face mounting external debts,
eroding international credit standing, and an impending financial crisis. Therefore, Korea's and
Taiwan's different experiences in achieving payments adjustment can provide valuable insights
for other countries in responding to future external shocks.
In Section I, we briefly survey the developments in the two countries' balance of payments
from 1973 to 1977. For both countries, the fluctuations can be attributed almost entirely to
changes in merchandise-trade balances; the latter, therefore, constitute the focus of this study.
In this analysis, the year-to-year change in each
country's trade balance is divided into a part due
to price changes and another due to changes in
the volume of exports and imports. By making
this distinction, we are able to isolate the "price
shock"-including the oil shock-and further
narrow the focus of this study to concentrate on
changes in export and import volumes.
Section II presents a simple framework for
analyzing trade-volume fluctuations in terms of
changes in income and relative prices. It calls attention to the similarities between the two countries' growth experiences during the 1963-73
decade. The two countries, as close competitors
in international trade, both depended on rapid
export expansion for sustaining their high economic growth. Under these circumstances, relative price changes-including exchange-rate
adj1lstments--ean be expected to significantly
affect each country's export demand and thereby
its income-growth rate. Changes in income will,
in turn, affect the country's import demand in
the adjustment process.
Section III presents the results of regressions
* Assistant Vice President and Economist, Federal Reserve
Bank of San Francisco. Janice Grubb provided research assistance for this paper.
37
for testing these relationships. The results indicate remarkably stable relationships over the
1952-76 period between export and import volumes on the one hand, and income and relativeprice changes on the other hand. This stability
was maintained despite the rapid growth and
economic transformation of the Korean and
Taiwanese domestic economies, and despite unusually large disturbances in the \vorld economy.
Preliminary data indicate that the relationships
continued to hold in 1977.
The regression results confirm the important
role of relative prices in determining the two
countries' export and import volumes. They suggest that the different adjustment paths followed
by the two countries largely reflected the difference in their exchange-rate policies. Taiwan experienced plummeting exports and stagnating
output in 1974, when it maintained a stable exchange rate in the face of large domestic price
increases and Korea's sharp exchange devaluation. Until 1976, when economic recovery from
the world recession became widespread, it managed to reduce its payments deficit only by
sharply curtailing its imports. Korea, in contrast,
through the exchange devaluation, was able to
maintain a steady export expansion and output
growth in 1975 in spite of the severe world recession. Thus, different exchange-rate policies made
Korea's export expansion possible and Taiwan's
import contraction inevitable.
The regression results also suggest that the income elasticities of world demand for Korea's
and Taiwan's exports are substantially higher
than the elasticities of the two countries' demand
forimports. These differentials help explain the
rapid. improvement in their trade balances from
1975 to 1977, as wen as their long-run trend of
steadily disappearing trade deficits. But as a corollary, our finding implies that as world income
continues to expand, both Korea and Taiwan will
find it increasingly difficult to reconcile domestic
economic-stabilization objectives with policies of
fixed exchange rates and restrictive exchange
and trade controls.
The high income elasticities of world demand
for Korea's and Taiwan's exports reflect the degree to which the two countries have successfully
adapted their output to world demand. Given a
steady growth in world income, both countries'
balance-of-payments prospects are reasonably
assured. This finding has significant implications
for the growth strategies of other developing nations, but has rather limited relevance for other
LDC's short-run balance-of-payments adjustment policies.
As for short-run lessons, Korea's and Taiwan's
experiences during the 1974-1975 period suggest
the critical role of a nation's exchange-rate policy. Exchange-rate flexibility enabled Korea to
achieve adjustment through export expansion;
exchange-rate rigidity compelled Taiwan to undergo income stagnation and import reduction.
However, exchange depreciation aggravated Korea's domestc inflation, while income deflation
helped Taiwan maintain domestic price stability.
Thus, the two adjustment paths reflected alternative choices with a short-run trade-off between
income growth and price stability.
I. Balance of Payments Developments, 1952-77
countries' foreign borrowings rose substantially
(Tablet). Korea continued to borrow heavily in
1976 and 1977, but was not a large net borrower
because its increase in official reserves largely
offset its net capital inflows. Taiwan meanwhile
reduced its borrowings, and in 1977 was a net
lender of more than $1 billion. For the 1974-77
period as a whole, both countries recorded substantial increases in external public debt outstanding, including liabilities to U.S. banks.
The large trade deficits of 1974 and 1975 have
been generally attributed to the "oil shock", i.e.,
For both Korea and Taiwan, the currentaccount deficits in 1974 and 1975 were large by
historical standards (Chart 1).1 Equally dramatic were the subsequent improvements, so that by
1976 both countries had regained the average
current-account balances that prevailed in 197273. This V-shaped pattern in their current accounts was repeated in their trade balances, and
in fact was dominated by the latter. The rest of
this article, therefore, will focus on the trade balance alone. 2
During the adjustment period of 1974-75, both
38
Chart 1
small importing country, the supply of imported
oil may be ass.umed to be perfectly elastic with
respect to price; hence, in Chart 2, the supply
curve S is horizontal. The oil-exporting countries' decision to raise the oil price from OPo to
OP 1 is depicted as a rise of the supply curve from
S to S', Equation (2) shows the resultant change
in the value of the country's oil imports as a sum
of two terms. The first term, Qo.6.P, shows the
change in import value when the elasticity of demand for imported oil is zero (Do in Chart 2), so
that the country imports the same quantity of oil,
OQo' as before the price increase. The resultant
rise in the value of imported oil is shown by the
rectangle AP 1P oEo' The second term, P 1tlQ, introduces the decline in the value of imported oil
when the country's demand for oil is price-elastic
(D in Chart 2). At the new price OP 1, the resultant reduction in oil-import quantity, QOQ 1, implies a decline in oil-import value, depicted by
the rectangle AEoQ oQ 1, from what the import
value would be if the demana were zero-elastic.
The first term, QaAP, measures the extent of the
"oil shock" to the country, which is proportional
to the quantity of its imported oil in the base year
Qo' The second term, P 1tlQ, measures the effect
on import value of the quantity change tlQ valued at current-year prices Pl'
From 1973 to 1975, both Korea's and Taiwan's
trade balances deteriorated by about $1 billion in
nominal terms (Table 2, Part A).3 In both cases,
the deterioration was attributable to a much
Current Account Balance and Trade Balance
Taiwan and Korea, 1952-1977
$ Millions (U.S.)
500 Forea
o
-500
-- u___
;'
!r
!
~ ~
A
~
1ir- ....~ D_I____
:::~t
-1000
Curreyt Account Balance
_-~~-',
',~ [1~
I I I I I I
'fn~\
I
I I
$ Millions (U.S.)
1000
Taiwan
500
Current Account Balance
V
o I-"~===::::#~_~
-500
A
Trade Balance
the quadrupling of oil prices in December 1973.
However, the oil shock was a part of a worldwide
price inflation, with wide fluctuations occurring
in individual countries' terms of trade. For analytical purposes, it would be desirable to find a
way to isolate the external shocks various countries received from the large price fluctuations in
the world economy.
A simple formula is used here for that purpose.
Since value equals price times quantity, a change
in the value of exports or imports from one year
to another can be split into two parts: one due to
price change at the base-year quantity, and the
other due to quantity change valued at the current-year price. Algebraically, the formula is derived as follows:
V = PQ
(1)
Hence, tlV = QotlP + PotlQ + tlPtlQ
=QotlP + PltlQ,
(2)
where V, P, and Q designate value, price, and
quantity respectively; the subscripts 0 designate
the base year and 1 the current year; and tl preceding a symbol designates the year-to-year
change in that variable.
Consider the case of an oil-price increase. For a
Chart 2
Price and Quantity Changes
Price
D
39
Table 1
Net External Borrowings, Reserve Changes and External Debts, 1971-77
(Millions of U.S. Dollars)
Average
1971-73
1974
1975
1976
1977'
Korea
Net External. Borrowings ..............
570
1,603
2,267
1,691
1,449
(Private and public)
Changes in Official Reserves ..........
160
-172
368
1,314
1,468
4,556
6,178
6,912
10,210
n.a.
n.a.
n.a.
2,604
3,252
3,948
-226
1,018
528
108
-1,088
178
42
12
410
-236
1,820
2,612
3,103
3,158
n.a.
n.a.
n.a.
1,810
2,578
3,458
(Increase: +)
External Public Debt Outstanding
(end of period)
U.s. banks .........................
Taiwan
Net External Borrowings ..............
(Private and public)
Changes in Official Reserves ..........
(Increase: +)
External Public Debt Outstanding
(end of period)
U.S. Banks . .......................
'Data are for the first three quarters at annual rates for net capital inflows and changes in reserves, and end of year for debts to
U.S. banks.
Sources: International Monetary Fund, International Financial Statistics, April 1978; World Bank, World Debt Tables, Vol. 1,
September, 1977; U.S. Treasury, Treasury Bulletin, February 1978; Federal Reserve Board, Statistical Release E. II,
various dates.
Table 2
Changes in Trade Balance
1973-75 and 1975-77'
(Millions of U.S. Dollars)
1975-77
1973-75
Imports
Trade
Balance
+5,039
+3,812
+1,227
+4,440
+2,875
+1,565
-1,776
+1,148
44
+
(+205)
+1,104
-
+
775
+ 647
(+131)
+
128
123
Trade
Balance
Exports
Exports
Imports
Korea .........
+1,719
+2,825
-1,106
Taiwan ...........
+ 825
+1,816
-
991
B. Prices
Korea ............
+ 547
+2,323
(+739)
+1,093
+1,523
(+269)
A. Value
(Oil Shock) ......
Taiwan ...........
(Oil Shock) ......
430
C. Volumes
Korea ............
+1,172
+
502
+ 670
+3,891
+3,768
+
Taiwan ...........
-
+ 293
561
+3,665
+2,228
+1,437
268
'The data are cumulative year-to-year changes during the respective periods derived by using Equation (2) in the text.
Sources: Based on data in International Monetary Fund, International Financial Statistics, April 1978; except for "oil shock"
data on the price of crude petroleum (Arabian Light, 34 gravity) which are from American Petroleum Institute, Basic
Petroleum Data Book, April 1978, updated by data supplied by the API.
40
and for 17 percent of Taiwan's increase (Table
2). Import-price increases accounted for 23 percent of Taiwan's import growth but for hardly
any of Korea's increase.
In real terms, Korea's exports increased 56
percent and Taiwan's 64 percent, while their imports rose 43 percent and 32 percent, respectively. In other words, Taiwan was much more
successful than Korea in holding its importgrowth rate below its export-growth rate. Thus,
Taiwan's $1.6-billion trade-balance improvement resulted mainly from its trade-volumeadjustment, while Korea's $1.2-billion improvement resulted mainly from improved terms of
trade. Put differently, Korea benefitted substantially more than Taiwan did from terms-of-trade
improvements during the 1975-77 recovery
phase.
A number of questions emerge from this analysis. First, what might account for Korea's much
stronger real-export growth in the 1973-75 period? Second, why did the two countries, with supposedly similar production and trade patterns,
react so differently in their trade adjustment during that period (stronger export growth for Korea, and stronger import restraints for Taiwan)?
Third, how did the two countries achieve such
spectacular real export growth during the 197577 recovery? Lastly, why did exports grow considerably faster than imports for both countries
between 1973 and 1977?
larger rise in imports ($2.8 billion and $1.8 billion, respectively) than in exports ($1.7 billion
and $0.8 billion). By applying Equation (2), we
can break down these nominal-value changes
into two parts -- one due to price changes (Table
2, Part B) and the other due to volume changes
(Table 2, Part C).
For both countries, nearly all the import increases during 1973-1975 were due to steep rises
in import prices (Part B). In terms of U.S. dollars, import prices rose 59 percent for Korea and
41 percent for Taiwan. 4 These price increases accounted for 82 percent of Korea's 1973-75 import increase and for 84 percent of Taiwan's
increase. The oil shock accounted for 26 percent
of Korea's, and 15 percent of Taiwan's total import increase.
Abstracting from price changes, changes in import volume (Part C) accounted for 18 percent of
Korea's $2.8-billion rise in imports, and for 16
percent of Taiwan's $1.8-billion rise in imports.
In real terms, the rise in import volume was 8
percent and 10 percent, respectively. For
Taiwan, the cumulative change in import volume
over the two-year period masks wide annual fluctuations, as will be discussed below.
During the 1975-77 period, both countries'
trade balances improved dramatically -- $1.2 billion for Korea and $1.6 billion for Taiwan, compar~d to the actual deterioration both suffered in
the preceding two-year period. Price changes accounted for 23 percent of Korea's export increase
II. Analysis of Trade-Volume Fluctuations
In seeking answers to these questions, we assume changes in prices and income as given, and
examine how Korea and Taiwan's export and import volumes reacted to these changes (see the
above description of Chart 2). Our basic premise
is that certain stable systematic relationships
existed during the 1973-77 period, between the
changes in the two countries' trade volume on the
one hand, and income and price changes on the
other.
More specifically, we assume that the demand
for each country's exports depends on world real
income, and on the price competitiveness of each
country's exports relative to competing goods in
importing countries and to exports of close com-
petitor countries. We further assume that Korea
and Taiwan are each other's closest export competitors, and that their exports are sufficiently
differentiated from each other and from goods in
the importing countries as to allow different
price movements, adjusted for exchange-rate
changes. Similarly, we assume that each country's demand for imports depends on its real income, and on the price competitiveness of
imported goods relative to its domestic products,
again adjusted for exchange-rate changes.
The two countries exhibited different patterns
of real output and prices during the 1973-77 period. Korea maintained a surprisingly high output-growth rate of 8.8 percent in both 1974 and
41
changed despite large domestic price increases in
1974 and trade deficits in 1974 and 1975. Korea,
on the other hand, devalued by 67 percent between 1963 and 1973 -- from 130 to 398 won
(W) per U.S. dollar, and then devalued another
18 percent to W484 in December 1974. Since
then, it too
a fixed
rate
against the dollar.
Although Korea's domestic inflation rate was
considerably higher than Taiwan's for most
years, the inflation-rate differentials were largely offset by exchange-rate adjustments. Thus, between 1963 and 1973, consumer prices increased
at a 12.4-percent average rate for Korea and at
only a 3.5-percent average rate for Taiwan, but
Korea's cost of living (in terms of U.S. dollars)
fell at a 3.4-percent average rate against
Taiwan's. In 1974, this cost-of-living ratio fell
another 18.2 percent because of Taiwan's sharp
price rise in that year, but the ratio rose steadily
thereafter as Korea's exchange devaluation
failed to offset that nation's higher rise in consumer prices.
1975 -- close to the 1O.3-percent average rate of
the preceding decade. However, this was attained only at the cost of a high domestic consumer-inflation rate, averaging 25 percent a
year. Taiwan took a somewhat different course.
Its output-growth rate dropped precipitously
from an annual average of 10.4 percent during
the1963~73 decade to 0.6 percent in 1974 and
2.4 percent in 1975. Meanwhile, its domestic inflation rate jumped abruptiy by 48 percent in
1974 and then dropped to an average rate of only
3.8 percent in 1975-76 -- about the same as in the
1963-73 decade.
Contrasts also showed up in the two countries'
exchange-rate policies. Taiwan abandoned a system of multiple exchange rates in 1963, and
thereafter maintained a fixed exchange-rate
policy except for one revaluation in February
1973. At that time, it revalued by 5.3 percent,
from 40 to 38 New Taiwan dollars (NT) per U.S.
dollar, in order to curb domestic inflationary
pressures arising from mounting trade surpluses.
Subsequently, it kept the exchange rate un-
IU. Regression Results
The regression equations derived in this study
postulate the following relationships:
Xi
is based on the fact that both Korea and Taiwan
import large amounts of materials, parts and
components for processing and assembling for
exports. Because of the time lag between placement of import orders and import arrivals, importers when anticipating future export demand
must rely upon such indicators as the current level of exports. Thus, the higher the current level of
exports, the larger will be the import orders for
future import arrivals. For simplicity, we postulate that the average lag is one year. 5
Because the regressions are designed to explain
the year-to-year percent changes in the two
countries' export and import volumes, rather
than their absolute levels, the demand functions
(3) and (4) are assumed to be of a constant-elasticity type:
a2
(5)
D = aoZ 1
= fey w, Pxi/Pw, Pxi/Pxj)
Equation (3) states that the demand for country i's real exports (Xi) is positively related to
world real income (Y w), and negatively related
to the ratio of its own export price to the world
price level (Pxi/Pw) and to the ratio of its own
export price relative to the export price of its
close-competitor country j (Pxi/Pxj). Equation
(4) states that the demand for country i's real imports (Mi) is positively related to its real income
(Yi ) and to its volume of exports during the preceding year (Xi,- I), and negatively dependent
on the ratio of its import price to the domestic
price (Pmi/Pi).
The lagged export volume is included in the import equation as a proxy for the market's expectation of the current year's volume of exports. It
where 0 designates the dependent variable Xi or
Mi,
and Z2 are the explanatory variables, and
the a's are parameters. Equation (5) can be rewritten in percent-change terms:
dOlO
42
= a1dZJZ1 + a2dZiZ2
(6)
or alternatively, in logarithms:
log D = log ao + a l logZl + a}ogZ2 (7)
In either case, the parameters a and a designate
demand elasticities with respect to Z 1 ~nd Z 2' respectively.
Regression equations of the percent-change
form (Equation 6) and the logarithmic form
(Equation 7) are estimated on the basis of annual
data for the years 1952-76. In the export equations, OECD real output is used to stand for
world real income (Y w), and a weighted average
OECD consumer-price index for world price level (P W).6 In the import equations, each country's
consumer price index is used for Pi. In all the regression equations, consumer prices rather than
wholesale prices are used, as the latter are more
likely to be influenced by changes in the prices of
internationally traded goods, and thus are more
reflective of world-market conditions than domestic-inflation conditions.
The regression results, presented in Table 4,
show that the best export equations for both
countries were of the percent-change form and
the best import equations of the logarithmic
form. Because of problems of multicollinearity
with Pxi/Pxj, the relative-price term Pxi/Pw had
to be dropped from the export equations. The
squared simple-correlation coefficient between
the two relative-price terms was 0.90. The regression coefficients of all the other variables
were of the correct signs and statistically signifi-
cant. The regression equations accounted for
varying portions of the variances of the dependent variables, with little or no evidence of significant serial correlation in the error terms.?
The regression results suggest stable relationships over the 1952-76 period (Charts 3-4)-a
period in which both countries became transformed from slow-growing agricultural economies to fast-growing manufacturing economies.
Moreover, the relationships continued to hold for
the 1973-76 period and for (projected) 1977,
with the unexplained variations falling well within one standard error of the respective regression
equations. Thus, the two countries' trade adjustments to the oil shock and the severe world inflation and recession of the 1973-77 period differed
from their experiences of the preceding twenty
years only in magnitude, not in kind.
What light can these regression results throw
on the central questions raised earlier? First,
there is the question of Korea's much stronger
export performance during the 1973-75 period.
Over that period, Korea's export volume rose by
33 percent, while Taiwan's fell by 6 percent. Our
regression equations relate changes in export volumes to changes in world real income and in the
two countries' relative export prices. Since both
countries' exports faced the same changes in
world real income, any explanation based on the
regression equations must come from the relative
price term.
Chart 3
Korea and Taiwan Exports, Actual and Predicted Values
Percentage
Change
120
Korea Exports
100
Percentage
Change
120
~
Taiwan Exports
100
80
80
60
60
40
40
20
20
OH¥'-i--Hii----------=---20
20
43
Predicted
y
Table 3
Economic Profiles of Korea and Taiwan, 1963-73 and 1973-77
(Percent Changes)
Average
1963-73
1973-74
1974-75
1975-76
1976~1977
Real-Output Growth
Korea
.
10.3
9.8
Taiwan
.
10.4
8.1
Korea
..
12.4
23.7
26.3
Taiwan
.
3.5
47.5
5.2
Korea. .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
16.9
29.0
7.1
30.8
10.5
-5.7
11.7
2.9
2.4
8.1
-67.42
4.62
-1.8
-16.2
- 0-
-0-
0.8
-0-
-0-
- 0-
-3.4
-18.2
0.7
12.5
3.9
1.2
-3.9
-1.4
8.9
-0.9
Consumer-Price Inflation
ElIpprtPrices in National Currency
Taiwan
,.
Exchange-Rate AdjUstment·
Korea
:....................
Taiwan...............................
Relative Consumer Prices in U.S.
Dollars3
Korea/Taiwan
Relative Export Prices in U.S. Dollars3
Korea/Taiwan
'Percent change in the value of the national currency against the U.8. dollar.
2Total change from 1963 to 1973, not average annual rate of change.
3Ratio of consumer-inflation rates or export prices in national currencies adjusted for exchange-rate changes.
Source: International Monetary Fund, International Financial Statistics, May 1978.
Table 4
Re9ression Results, Export and Import Functions
(Annual Data: 1952-76)
1. Exports. Korea
AXk = 6.74 + 4.63AYw - 0.507A(Pxk/Pxt),
(0.75) (2.50)
(2.14)
R2 = 0.231,8 = 23.5, OW = 1.90, N = 24.
2. Exports, Taiwan
AXt = 3.29 + 4.13AY w - 1.I8A(Pxt/Pxk),
(0.003) (3.35)
(6.89)
R2 = 0.730,8 = 16.0, OW = 1.52, N = 24.
3. Imports, Korea
1nMk = -3.80
(1.46)
R2
+ 1.19
(2.57)
1nYk - 0.987 In(Pmk/Pk)
(3.12)
= 0.962, 8 = 0.235, OW = 1.97, N
+ 0.311
In(Xk)-I,
(2.16)
= 24.
4. Imports, Taiwan
1nMt
= 0.323 + 0.550 InY t (1.33)
(5.06)
0.970 In(P mt/P t )
+ 0.567
(4.56)
In(X t )-I,
(8.95)
R2 = 0.982,8 = 0.110, OW = 2.27, N = 24.
Notes: (a) For explanations, see the text.
(b) The t-statistics are shown in parentheses under the regression coefficients.
44
From 1973 to 1975, the ratio of Korea to
Taiwan's export prices in U.S. dollars declined
by 5.3 percent (Table 3); alternatively stated, the
ratio of Taiwan to Korea's export prices rose by
5.6 percent. When these relative price changes
are multiplied by the price elasticities obtained
from the respective export equations-o.507 for
Korea and 1.180 for Taiwan (Table 4)-the results indicate that relative price changes accounted for less than 10 percent of the rise in
Korea's export volume, 8 but for more than the total decline in Taiwan's export volume.
In terms of national currencies, Korea's export
prices actually increased by 15.6 percent more
than Taiwan's export prices during the 1973-75
period (Table 3). Yet, Korea was able to more
than offset the higher price rise by an 18-percent
currency devaluation in 1974 on top of Taiwan's
5.3-percent currency appreciation in 1973. Thus,
different exchange-rate policies helped account
for much of the difference in the two countries'
export performance in this period.
The second question refers to the apparently
different adjustment paths followed by Korea
and Taiwan for reducing payment deficits. On
the export side, the difference could be attributed
largely to different exchange-rate policies, as we
have just seen. On the import side, most of the
change in import volume could be attributed to
income, relative prices, and to lagged exports
(Table 4). A notable exception, however, was the
sharp 12-percent decline in Taiwan's import volume in 1975, which was opposite to what would
be expected on the basis of our regression equation(Chart4). A detailed examination of this
episode may help explain the paradox.
Taiwan's economic growth during the last fifteen years has been featured by an increasing dependence on export demand. The export share of
total output jumped from 13 percent in 1963 to
46 percent in 1973, partly on the basis of a 62percent export increase in 1971-73 alone. But
then exports actually declined 6 percent over the
ensuing two-year period, representing a severe
setback to Taiwan's economy. In 1974, Taiwan
recorded a 0.6-percent increase in real output,
but only because of a sixfold increase in inventory accumulation. lO Then, in 1975, while exports remained weak, real output rose by 2.4
percent, primarily on account of an unprecedented 12.l-percent increase in real government consumption expenditures and a 52.2-percent
increase in fixed capital formation by public corporations and government enterprises." But for
the extra spending, on inventories in 1974 and on
government projects in 1975, real output would
have declined about 6 percent in both years.
Under these circumstances, Taiwan still managed to reduce its volume of imports. First, in order to maximize the intended output-expansion
impact, the government allocated its extra purchases mostly to domestic products rather than
Chart 4
Korea and Taiwan Imports,
6248
$ Millions (U.S.)
Actual and Predicted Values
$ Millions(U.S.)
4000
4000
Taiwan Imports
Korea
3000
3000
2000
2000
1000
1000
0195355
60
45
A
If
Predicted"
{I
f/
Actual
Chart 5
imports. Second, as exports declined, it imposed
additional. import restrictions (including surcharges and cutbacks in permits), partly as a
trade-adjustment measure and partly as a means
of diverting demand to domestic products. Neitherof these two developments would have been
reflected in our import equation.
In short, Taiwan's adjustment through income
deflation was not a result of deliberate economic
policy, but rather was imposed on the economy
by the unexpected export decline, which in turn
was caused by Taiwan's 1973 currency appreciationandKorea's 1974 currency devaluation.
Thus,underiying the difference in balance-ofpayments adjustment was a different approach
to exchange-rate adjustment: Korea's readiness
to adjust its exchange rate when needed, and
Taiwan's strict adherence to a fixed exchange
rate in the face of sharp domestic price increases
and a sharp currency devaluation by its close
trade competitor.
The third question to be examined has to do
with the spectacular export growth of the 197577 period, amounting to 56 percent for Korea
and 64 percent for Taiwan, in real terms. During
that period, world real income rose by 8.5 percent, while Korea's export prices in U.S. dollars
rose. by 7.9 percent relative to Taiwan's. When
these changes are multiplied by the respective
elasticities derived from the two export equations, the results indicate that world income
growth accounted for 40 percentage points of
Korea's export growth and 35 percentage points
of Taiwan's; and that the change in relative export prices reduced Korea's export growth by 4
percentage points and increased Taiwan's by 9
percentage points. Thus, our regression results
indicate that the two countries' remarkably
strong export growth was largely due to world
economic recovery, combined with the world's
high income elasticities of demand for the two
countries' exports. Relative export prices played
a minor, though not insignificant, role during
that period. 9
Finally, there is the question of why both countries have experienced faster growth of exports
than of imports over time. Export-import ratios
for both countries showed an unmistakable up'Nard trend after 1960, except for a flattening-off
Export-Import Ratios, 1952-1977
~
40
Korea
30
20
in the second half of the 1960's and a sharp dip in
1974. Both ratios resumed their rise after 1974
(Chart 5). The upward trends imply that both
countries· were paying for an increasing portion
oftheir imports through exporting. In Taiwan's
case, exports have exceeded imports almost every
year since 1969.
Our regression results suggest that the world's
income elasticities of demand for Korea's and
Taiwan's exports (larger than four) were much
higher than these countries' income elasticities of
demand for imports (roughly one). Unless offset
by higher economic growth rates, the differences
in income elasticities would lead Korea and
Taiwan to show faster export growth than import
growth. From 1960 to 1973, OECD real output
grew at a 4.9-percent annual average rate, while
Korea's angTaiwan's output grew by 9.2 and 9.7
percent a year, respectively. In neither case was
the growth-rate differential sufficient to offset
completely the income-elasticity differential.
The income elasticities have been derived on
the ba.sisof stable relationships extending over a
46
quarter-century. Thus, the upward trend in Korea's and Taiwan's export-import ratios is likely
to continue, in the absence of basic structural or
policy changes which reduce the world's income
elasticity of demand for their exports or increase
their own elasticity of demand for imports. For
international bankers, this
that both
countries wiII remain good credit risks. But at the
same time, the upward trends could portend difficult policy choices for these countries.
Given the limited scope of monetary-policy instruments in Korea and Taiwan, the authorities
might encounter difficulty reconciling domestic
stabilization objectives with policies of fixed exchange rates and restrictive exchange and trade
controls. In order to relieve the increasing inflation pressures arising from growing trade surpluses and mounting foreign reserves, the two
countries might be forced to revalue their currencies and/or liberalize the exchange and trade
controls which were imposed during an earlier
era of foreign-exchange shortage. The policy
choice might be complicated by their traditional
reliance on export expansion for economic
growth, as well as the strength of the domestic
interests arrayed against trade liberalization.
IV. Summary and Conclusions
Korea's IS-percent devaluation in 1974 on top of
Taiwan's 5.3-percent appreciation in 1973. The
exchange-rate changes made Korea's export expansion possible and Taiwan's import contraction inevitable. The different adjustment paths
meant, for Korea, sustained output growth at the
expense of domestic price stability, and for
Taiwan, income stagnation coupled with a low
rate of domestic inflation. The former reflected a
deliberate demand-management policy aimed at
rapid income growth, and the latter reflected an
adherence to fixed exchange rates and a policy
focused on the maintenance of domestic price
stability.
3. During the 1975-77 period, both countries'
trade balances improved rapidly, primarily because of world economic recovery coupled with
high world-income elasticities of demand for the
two countries' exports. In addition, Korea was
particularly helped by improved terms of trade.
4. The world's income elasticities of demand
for Korea's and Taiwan's exports are substantially larger than these countries' income elasticities
of
for imports. The differences heIp account for a long-run rising trend in both countries' export-import ratios. This suggests small
credit risks for these countries, but it could also
portend difficult policy choices-between domestic stabilization on the one hand, and continued .restrictive foreign-exchange and foreigntrade policies on the other. How the two countries resolve this policy dilemma wiII be fascinating to watch.
Like other oil-importing developing countries,
Korea and Taiwan sustained unprecedentedly
large payments deficits in 1974 and 1975. Yet,
barely two years later, both had succeeded in
eliminating the deficits. The two appear to have
followed different adjustment paths-Korea
through export expansion and output growth, at
the cost of severe domestic inflation, and Taiwan
through import contraction and relative price
stability, at the cost of temporarily reduced output growth. Each country was successful in its
own way, but the approaches to success were different.
This study has sought to develop some explanation for these contrasting success stories. By isolating the impact of price changes, we were able
to concentrate on trade-volume changes. On the
basis of regression equations, we found that the
wide and divergent fluctuations in trade volumes
largely reflected several key explanatory factors.
1. During the 1973-75 period, Korea sustained a much more severe oil shock and termsof-trade deterioration than Taiwan. Yet, Korea
was able to reduce the resultant trade deficit
through export expansion and restrained import
growth. In contrast, Taiwan's imports increased
and exports decreased, worsening its trade balance.
2. After the initial shock in 1974, both countries reduced their trade deficit in 1975: Korea
primarily by continued export expansion, and
Taiwan by drastic reduction in imports. The difference in their adjustment paths largely reflected their exchange-rate policies: in particular,
47
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FOOTNOTES
1. The current account balance is defined here as the sum of the
balance on the goods-and-services account and the net private
and government unrequited transfers (i.e., remittances, dona·
tions and grants) in a country's international balance of pay'
ments.
2. However, a few remarks on the service transactions, unrequited transfers, and foreign borrowings are in order. For most
years, Korea had large net receipts from U.S. Government
grants, services provided by Korea to U.S. military forces stationed there, and remittances from overseas Koreans. Taiwan
did not have such receipts to any significant extent. Its serviceaccount balance ran a steadily increasing deficit since 1967, reo
flecting mainly rising shipping and transportation costs for
Taiwan's growing volume of foreign trade-a development
which was also evident in Korea's service transactions. Moreover, in recent years, especially since 1974, both countries have
been making large and increasing amounts of interest and divi·
dend Pllyments to foreigners.
3. In actual calculation, AP in Equation (2) is converted to percent-change terms by rewriting the formula as
AV = VoAP/Po + P,AO
whereAV, Vo, and AP/Po are all readily obtainable from publishedliata, and P,AO is derived as a residual.
4. Data cited in this and the following paragraphs, but not shown
in Table 2, are from IMF, International Financial Statistics,
April,197a.
5. SOrn ll statistical complications may be introduced by the use
of a lagged variable. The relationship between the export vol·
umeand the import volume may in fact be contemporaneous, so
thaUhe lagged exports may be a proxy for lagged imports, rather than for export expectation. In that case, certain statistical
tests, such as the Hest and the Durbin-Watson test, would not
be applicable.
6. Both sets of data are published in OECD, Main Economic
Indicators, various issues, for 1960-76 only. For the years
1952-59 the U.S. real GNP series was spliced to the OECD output series, and the U.S. consumer-price series to the OECD
price series, through simple regressions. In both cases, the
squared correlation coefficient was about 0.90.
7. The only exception is the Taiwan export equation, which hils
a DlIrbin-Watson statistic within the critical range at the 5 percentsignificance level, indicating a probable positive serial correlationof a fairly low magnitude (aboutO.24).
a..That the reilitive-price term accounts for so small a portion of
Korea's export growth is disappointing. It reflects the relatively
poor fit of the Korea export equation, as shown in Chart 3, indicating the presence of some powerful factors-e.g: technology
and markllting improvements, export-promotion measuresthat are not captured by our regression equation. Nevertheless,
the Durbin-Watson statistic (1.90) is so close to 2 that there appears to belittle systematic error in the specification.
9. Why thll world's inc:omll elasticities of demand for the two
countries' exports are so high is an interesting question not pursued in this article. It would be useful to compare these with the
world's income elasticities of demand for other countries' exports, 10.see whethertho$e for Korea's and Taiwan's product
are indeed significantly higher; and if so, why.
10. The data cited in this paragraph are based on DirectorateGenerl;\1 of~lIdget, Accounting anli Statistics, Executive Yuan,
Natlon~llncol'l1e of tMRePublic of China. December 1976,
especially pp. 83 and 123.
11.AIl capital-formation data are in nominal values, as data on
capital formation l;\ccording to purchasers are not available in
real terms.
48
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