Integration withIntegration with

the Global Economy:the Global Economy:

A StructuralA Structural

MacroeconometricMacroeconometric

Modelling of KoreaModelling of Korea

Jarir Ajluni

Background

Background: The Korean Miracle

Key Achievements of the Korean Economy

Growth. (GDP per capita doubled 11 times during 1960 – 2003)

Exporting Boom. (Gross exports increased by 6000 times!)

Industrialisation (increased share of manufactured exports)

Financial Development (financial Depth in M2/GDP). Attractive destination for FDI. Joining the OECD!

Background: The Korean Miracle

Key Challenges to the Korean Economy

Oil Price Hikes (OPEC oil price shocks 1973 & 1979)

Integration (increased exposure to global fluctuations)

Geo-Political Constraints. Corruption. The Asian Crisis of 1997

(currency crisis, increased interest rates, doubled Unemployment, recession)

Modelling Strategy

The Theoretical Framework

The IS-LM-BP Framework R, ex

y

ISLMBP

Purchasing Power Parity PPP pep

Rpmy )(yyppeRR )(

yRppey )(1

LM

BP

IS

)5....(..................................................

)5..(..........

)5...(..........

)5(...........................................)(

434241044

13353433323103,3

272625242322022

111312011

dpped

ctdyppeRRyd

byRppeyd

atdyRpmd

ttttt

tttttttt

ttttttt

ttt

Core Model

Econometric Formulation of IS-LM-BP-PPP leads to:

Error terms above are “Deviations from Equilibrium”

Classifying trading partners

Trading partners are grouped into:

I. United States (US).

II. Rest of the G7 (RG7).

III. Rest of the OECD countries (ROECD).

IV. Developing Oil Exporting Countries (DOEC).(including OPEC & non-OPEC exporters)

V. Rest of Developing Trading Partners (RDTP).

)1.6(......

1

W

fhfthft

hfthfthft

IMEX

IMEX

)2.6(..............

1

1

W

fhfthft

F

fhfthft

hjt

IMEX

IMEX

)3.6(.......

1

1

1

1

N

jhjt

W

fhft

Construction of the Trade Weights

Country Trade Weights (h: home f: foreign economy)

Regional Trade Weights (h: home j: Region)

Aggregation conditions holds:

Directions of Trade 1980 - 2000

24%

33%6%

24%

13%

US RG7 ROECD DOECs RDTPs

21%

26%

8%

20%

25%

US RG7 ROECD DOECs RDTPs

36% of trade towards Developing countries 45 % of trade towards Developing countries

Importance of the G7 group: US and Japan

)8(..1 1 1

111

0

q

i

N

j

q

ititititjij

N

j

tjj

q

iithitth

q

i

q

ititititGitG

q

iithitth

1 111

10 )9(.....

)7.....(1 1

N

j

F

ffhfthjtGt X

Construction of the Model

Global vector by using trade weights of (6.1) (6.2)

VAR in (8) would be written in the form of (9)

VECM & Partial Systems

)10.........(1

ti

itiitt t

G

h

G

h

G

h

G

h

X

X

it

p

i Xi

Xi

it

X

X

t

X

X

Gt

th

c

c

1

1

Gthtt Let vector Z be:

Then the VECM of (9) would be :

tGtGtGtGtGt Rmpy ,,,,

hththththt Rmpy ,,,

then we could split (10) into:

Weak Exogeneity imply: 0GtX

434241

34353331

272326232524

1213

0000010

010010

0001

00000010

Identification

krrkkk

)10.........(1

ti

itiitt t

Recall VECM:

applying restrictions from (5a – 5d) derived from IS-LM-BP-PPP.

Empirical Results

Presence of 4 Cointegration relationships. Identification restrictions rejected. Weak Exogeneity of Global Vector & Oil Price. Low Capacity for an Independent Monetary Policy. Evidence on higher interest rates strangling the

economy (Stiglitz was right!).

Empirical Results

Response of yResponse of p

Respose of e

Impulse Response Functions

Response of (m-p)

Response to domestic monetary policy shock

Response of y

Response of (m-p)

Response of p

Response of e

Response to foreign monetary policy shock

Response of R

-0.1

-0.05

0

0.05

0.1

0.15

0.2

0.25

0.3

0.35

0.4

Response to foreign monetary policy shock

Foreign Monetary Policy Shock

-0.1

-0.075

-0.05

-0.025

0

0.025

0.05

0.075

0.1

0.125

0.15

0.175

0.2

0.225

0.25

0.275

0.3

0.325

0.35

0.375

0.4

0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20

step

IRF of y IRF of p IRF of (m-p) IRF of e IRF of R

Emphasise the relative responsiveness

Oil Price Shock

-3.5

-3

-2.5

-2

-1.5

-1

-0.5

0

0.5

1

1.5

2

2.5

0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20

step

IRF of y IRF of p IRF of (m-p) IRF of e IRF of R

Raising the Interest Rate is NOT effective in generating capital inflow supporting the exchange rate, other factors should be considered.

High responsiveness of the Interest Rate suggest Monetary

policy would not be independent and should target domestic financial system & inflation NOT the exchange rate.

The importance of adjusting to foreign monetary policy shocks: The Best Response proposition.

Policy Implications

7.2

7.4

7.6

7.8

4.45

4.5

4.55

4.6

7.5

88.

5

510

1520

25

6.8

77.

27.

41997q1 1999q1 2001q1 2003q1

1997q1 1999q1 2001q1 2003q1 1997q1 1999q1 2001q1 2003q1

Forecast for y_sa Forecast for p Forecast for h

Forecast for R Forecast for ex

forecast observed

Testing the Model’s forecasting validity

Root Mean Square Errors: y : 0.33429p : 0.278432m-p: 0.65651R :26.25877e : 0.960