Finance block

The finance block covers the yield of corporate bonds and the exchange rate. The yield on corporate bonds is determined by an official interest rate by a central bank, which allows the model to analyse the effects of the current monetary policy utilising an official interest rate on the real sector of the economy. The exchange rate determined by the difference between foreign and domestic interest rates has impacts on exports and imports in the foreign trade block.

43 It is important to note that the GDP variable on the right hand side is an independent variable, so that the GDP is not designed to be affected by the money supply in this model. Thus, we do not need to impose any restrictions on the coefficient in order to satisfy a theory of neutrality of money.

3.3.2.5.(a) Yield of corporate bonds

Determining the official interest rate by an independent central bank is the main monetary instrument to control inflation and stabilize output in the short-term. In practice, the call rate is the key interest rate that Bank of Korea charges commercial banks for secured overnight lending. The mechanism that transmits central bank policy actions to the real sector is as follows: a change in the official interest rate is transmitted to market interest rates, the exchange rate and asset prices. These changes in turn affect individual and firms‟ behaviours in terms of consumption, production, saving, and investment.

However, the transmission channel is somewhat complex, since the indirect effects can take various forms depending on macroeconomic aspects, financial market structure, and the regulatory framework. Numerous studies have attempted to explain how changes in central banks‟ policy rates transmit to market-determined rates (Dodds and Ford, 1972;

Diebold and Li, 2006; Diebold et al., 2006; Hoffmeister et al., 2010). A common reduced form is that the interest rate is a function of the official interest rate (CALL) and macroeconomic variables such as GDP (Y) and money supply (M3) representing the demand of fund and total liquidity in a nation respectively.

The estimation results for the yield of corporate bonds are described in Table 3.18.

The calculated F statistics shows that a long-run equilibrium relationship among variables exists. The coefficients on explanatory variables have all right sign; the yield of corporate bonds is positively related to output and negatively affected by liquidity, but are statistically significant only for the lagged dependent variable and the official rate. Even though the

historical relationships between the output and liquidity are not solid, the model retains the variables for simulation, since the sign and magnitude of coefficients does not violate macroeconomic theory.

Table 3.18. Estimation of the yields corporate bonds function (a) Regression model

Dependent Variable : Sample : 1971 ~ 2011

Regressor Coefficient Standard Error T-value P-value

Constant -15.017 16.536 -0.908 0.379

0.474^*** 0.137 3.451 0.004

0.525^*** 0.070 7.475 0.000

-0.162 0.254 -0.638 0.534

0.605 0.731 0.828 0.422

Note: ^***,^**, and ^* indicate significance at 1 %, 5 %, and 10 % respectively.

Estimation includes dummy variables equal to unity for the period 2000 and 2009.

(b) Cointegration test : = 4.982^**

(c) Diagnostic tests

̅ = 0.970 = 2.227

̂ = 0.097 = 110.004 (0.000)

= 0.929 (0.353) = 0.048 (0.976)

= 0.610 (0.449) = 0.716 (0.643)

Note: the right-hand side value in parentheses indicates p-value

3.3.2.5.(b) Exchange rate

This model uses the nominal exchange rate of Korean won to U.S. dollar for two reasons; first, the U.S. dollar is the key currency, so that the majority of international trade in Korea is settled by the U.S. dollar. Second, an official Real Effective Exchange Rate (REER)⁴⁴ is not readily available in the current SNA system.

44 REER is weighted average of a country's currency relative to a basket of other major currencies adjusted for the effects of inflation

As for model specification, given a major factor, the U.S.‟s interest rate in a small open economy, most macro-econometric models published in the bank of Korea and national economic institutes in Korea model the exchange rate equation by the difference between domestic and foreign interest rates. It is consistent with the theory of the Uncovered Interest-Rate Parity (UIP).

The nominal exchange rate ( is modelled by the ratio of the domestic interest rate and the foreign interest rate. The exchange rate function is given by:

where the official interest rate is adopted as the domestic interest rate and United States‟ government bond yield for 10 year is employed as the foreign interest rate.

Note that a difference between equation (3.67) and the UIP is whether the expected future spot exchange rate is included or not. The traditional macro-econometric model has a limited ability to model the expectation variable (the expected future spot exchange rate at time, t+k) contained in the UIP. It can be estimated under the assumption of perfect foresight (using real data at t+k). But it cannot be solved for simulation in a system model as it contains a future variable. Overall, the model has to consider both the theoretical and practical aspects of the problem

The estimation result for the log linearized form of equation (3.67) is presented in Table 3.19. The short-run and long-run elasticity of exchange rate with respect to the ratio of the domestic interest rate and the foreign interest rate are -0.076 and -0.123 respectively.

Although the coefficient on the difference between domestic and foreign interest rates is not

statically significant, the coefficients have the right sign; an increase in the domestic interest rate decreases the exchange rate (i.e. the domestic currency appreciates).

Table 3.19. Estimation of the exchange rate function (a) Regression model

Dependent Variable : Sample : 1990 ~ 2011

Regressor Coefficient Standard Error T-value P-value

Constant 2.461^** 1.136 2.167 0.047

0.644^*** 0.163 3.959 0.001

-0.076 0.083 -0.914 0.375

Note: ^***,^**, and ^* indicate significance at 1 %, 5 %, and 10 % respectively.

Estimation includes dummy variables equal to unity for the period 2001 and 2008.

(b) Cointegration test : = 8.614^***

(c) Diagnostic tests

̅ = 0.937 = 1.756

̂ = 0.042 = 52.810 (0.000)

= 0.139 (0.715) = 6.226 (0.044)

= 0.027 (0.871) = 0.573 (0.720)

Note: the right-hand side value in parentheses indicates p-value