This paper attempts to develop a simple model to
explain the dynamics of inflation in Korea. Inspite of the very
small size of the model, comprising only three equations, and its
highly aggregate nature, the simulation closely approximated the
actual past rates of inflation and real GNP growth.
Since real GNP is an endogenous variable in this model,
the interaction between prices and real GNP is fully reflected.
The price level is viewed to be determined in the adjustment
process of both the money market and the product market. The
more money that is supplied per product available and the higher
the speed of transactions, the more rapidly prices rise.
Meanwhile, given the supply capacity of the economy in the
short run, prices should rise quickly as costs increase rapidly
and real GNP approaches the full-employment level. Among the
important cost elements, the wage rate has been selected as an
endogenous variable because of its highly endogenous nature.
This simultaneous system and the two-stage estimation of the
model are expected to eliminate a simultaneous equation bias
and the error arising from inaccurate specification.
Although we tried to analyze the money supply behavior
of the authorities by estimating money multiplier equations, we
found that the money supply is basically exogenous in nature in
the sense that it is not directly explainable by the endogenous
variables of the model. Furthermore, the monetary authorities in
Korea, despite evidence to the contrary, are confident that they
can keep the money supply under control. Thus, this simple
model with an exogenous money supply is more suitably geared
to answer the question of optimal money supply.
The estimation results of the magnitude of the
coefficients for the major explanatory variables were largely
consistent with what is implied by the quantity theory of money
and the share of included cost factors in total manufacturing
When static and dynamic simulations were carried out
within the sample period, the tracking ability of the model was
excellent for the rates of inflation and real GNP growth. We
also confirmed that the model is stable to an exogenous shock,,
though the effects of a change in the money supply and imports
are rather long-lived. Furthermore, we found that the long-run
elasticities of price and real GNP with respect to the money
supply are roughly the same.
Finally, simulation exercises were made to forecast
prices and real GNP for 1978-80 under alternative sets of
assumptions about the major exogenous variables. Since a
moderate discrepancy was found between the forecast and the
targets, we also attempted to demonstrate how a policy mix can
be designed to attain the desired rates of inflation and real GNP
growth. The results of the simulation exercises indicated that
the planned rates of money supply increase for 1979-80 are too
low to achieve the target rate of real GNP growth. Also
suggested from the exercise as a possible means of attaining
both stability and the growth of the economy is the appreciation
of the Korean won, a proposal whose feasibility should be
judged in consideration of its effect on the balance of payments.
The simulation model will continue to be refined so that
it may better serve as a reliable and comprehensive guide in the
formulation of economic policies. Especially, the balance of
payments should be included in the model to demonstrate the
impact of changes in exogenous variables on the balance of
payments and the link between the money supply and the
balance of payments. In addition, the measurement of the
potential GNP should be improved and the product market
disaggregated into agricultural and non-agricultural sectors.