What Is a Monetary

Policy?
Lecture 2
1. Goals of Economic Policy
• What is the economic policy? Generally it refers to the action
of state or government to affect the economic performance
of a nation. Precisely, it refers to the action of state that
defines the economic and social objectives and use
appropriate instruments to attain these objectives.
• What are then the objectives of economic policy?
• Growth
• Redistribution
• Stabilization
 GROWTH ->Productivity Growth

STABILIZATION -> DISTRIBUTION ->

Countercyclical Policy Cohesion Policy
Shortage Economy

Queueing No meat to sell

Affluent society

Unsold houses Unsold cars (Source: Guardian, Jan. 16, 2009)

• What is the goal of macroeconomic policy?
• - Stabilization
• - It started with the birth of Keynesian economics.
• - fiscal and monetary policies: Central bank, along with
national tax system, is the essential economic institution
supporting nation-state.
Divided Nation
Alesina et al (2004). Fighting Poverty in the
US and Europe: A World of Difference
• Americans and European think differently about poverty,
inequality, redistribution, social protection and welfare.
• For Americans: the poor should help themselves.
• They are not less happy when inequality increases.
• For Europeans: the government is primarily responsible to lift
people out of poverty.
• They consider themselves less happy when inequality
increases
• Then why were Europeans so concerned about inequality?
• The views on social protection is different.
• - World Value Survey: 60% of Americans believed that the
poor were lazy, a view shared by only 26% of Europeans. In
contrast, the almost exact opposite proportions (60% of
Europeans and 29% of Americans) believed that the poor
were trapped in poverty.
• - The Americans don’t mind inequality because they think
they can climb the social ladder, while the European poor see
inequality as an insurmountable obstacle.
2. Priority Setting in Korea
• The national agenda for late President Park was
industrialization and export promotion.
• Korea joined the General Agreement on Tariffs and Trade
(GATT), adopting the negative-list Trade Program (under
which, any items, unless specifically listed, could be imported),
in 1967.
• Korea has made export-oriented economic development as
the biggest beneficiary of multilateralism.
(1) Growth and Liberalization
• Korea Achieved Remarkable Trade Growth in Multilateralism
for 50 Years after Joining GATT (from KITA (2017/04/17))
• MFN (most-favored nation) and tariff concessions
• The import liberalization ratio, the proportion of
automatically approved items in total import items, rose from
12 to 60 percent.
• Import policy may be graphically summarized as in Figure 1,
which shows the average tariff rates and “quantitative
restriction” liberalization index, the latter being the ratio of
the number of automatically approved items over total
importable items.
Import Liberalization

Source: Sakong-Il eds,THE KOREAN ECONOMY Six Decades of Growth and Development
Per capita growth rates in Korea,
Japan and China
Korea
24000

Japan

12000

Japan 1952=3094
Korea 1973=3224
China 1994=3095 China

6000

3000
1971 1975 1980 1985 1990 1995 2000 2005 2010 2014
(For Korea)

1950 1972 1993 2014 (For Japan)

1992 2014 (For China)

Source: Penn World Table

• More importantly, Korea aggressively pursued FTAs with other countries
and regions.
• Since its first FTA with Chile in 2004, for instance, Korea saw its first big
FTA with the ASEAN ratified in June 2007. Then it ratified the FTA with
the EU in July 2011 and the FTA with the US in August 2011. Finally,
Korea had its ratification of FTA with China in December 2015.
• Currently more than 70% of Korea’s imports are coming from the FTA
partners. These FTAs helped Korea to remove a tariff rate of around 8%.
Furthermore, they led to the development of direct overseas on-line
shopping.
• According to Kwark and Lim (2017), the FTAs reduced the CPI inflation
by 0.76 % point on annual basis during the period 2004-2015.
Figure 3: Share of Imports from FTA Partners
90

80

70
Korea-China FTA

60

50

40
Korea-EU FTA
Korea-US FTA
30

20 Korea-ASEAN FTA

10

0
2004/01 2006/01 2008/01 2010/01 2012/01 2014/01 2016/01 2018/01 2020/01 2022/01

Source: Author’s calculation and ECOS, BOK

(2) Stability and CESP
• Until the year 1979, Korea had to suffer from budget deficit, high
inflation rate and current account deficit.
• Korean government launched the first important stabilization program
in April 17, 1979 under the title of “Comprehensive Economic
Stabilization Policies (CESP)”.
• It marked “a paradigm shift in economic policies” because the then
dominant economic framework based on the HCI drive and the
government-led economic development strategy in general had to be
challenged.
• It is important to note that, unlike the ordinary stabilization which refers
to emphasizing more on controlling inflation and less on growth, the
CESP included much broader objectives such as making Korean
economy freer through the promotion of market mechanism and more
open through the enhancement of competition.
Kim Jae-ik
• After the leadership change from President Park Junghee to
President Chun Doo-hwan by military force, Kim Jae-ik, who had
worked for the EPB, was appointed as the Senior Secretary for
Economic Affairs. Gaining President Chun’s trust, he was able to
implement economic stability policies on a large scale.
• “Indeed Kim Jae-ik was a failure among the government officials
before he became an economic tutor to Chun Doo-hwan. Since
being appointed as the Director of the Economic Planning
Department of the EPB by Vice Prime Minister Nam Dukwoo in
1976, Kim experienced a series of failures and frustrations in spite
of ceaseless efforts to change his novel ideas into policies. He was
like a lonely white heron, bullied by other officials.”
• Kim Jae-ik believed that the bad practices of government spending
should be corrected to achieve real price stability.
• Thus, when he was a member of the National Security Council, he
attempted to insert a new provision into the Constitution to ban the
government from borrowing money from the Bank of Korea (BOK).
• It was such a revolutionary idea to remove the fundamental reason
behind the BOK increasing the issuance of currency by prohibiting the
government from borrowing the money from the BOK in the first place.
• As an alternative to borrowing from the BOK, he suggested a budget
freeze; by freezing the budget to the level of the previous year, the
increase in tax revenue could be the surplus to pay back the loans to
the Bank of Korea.
Senior Secretary Kim and His Memo (From
Jang(2013), KDI)
• Along with its tight fiscal policy, the Korean government
implemented tight monetary policy to control inflation.
• The first half of the 1980s was probably the most successful
stabilization period in Korean history.
• The inflation rate in terms of the Consumer Price Index (CPI)
that hovered around 20 percent per annum was stabilized to
around 3 percent from 1983.
• As inflation was stabilized, the export competitiveness of the
Korean economy was secured and the Korean economy
regained its growth momentum.
Growth and Inflation (%)
35.0

30.0

25.0

20.0

15.0

10.0

5.0

0.0
1970 1971 1972 1973 1974 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990

-5.0

Growth rate Inflation rate

(3) Income-led Growth, Redistribution(Social)
Policy or Growth Policy?
• Export (or trade) and investment were two leading
engines of growth.
• The 1997 currency crisis was a turning point for Korea
because its investment share had to fall substantially.
It brought about a moderation in the economic
growth. (Predict what will happen for China)
• For Korea, export-based growth remained only valid.
 10
20
30
40
50
60

0
1990
1991
1992
1993
1994
1995
1996

KOR
1997
1998

Source: World Bank

1999
2000

JPN
2001
2002
2003
2004
CHN

2005
2006
2007
USA

2008
2009
2010
2011
DEU

2012
2013
2014
2015
2016
2017
Export shares (% of GDP)

23
• Putting the experiences of Korea and Japan in contrast will be
enlightening.
• While Japan has continued to rely on domestic consumption
and managed to maintain its old employment system, Korea
has been relying on export-based growth.
• What makes these two countries different is that, unlike Japan,
Korea has been active in globalization, making its export
share increasing even after the 2008 global financial crisis.
Growth rates of household income by
income brackets, Korea
• Export-oriented growth is now dissuaded.
• Instead, President Moon came up with the idea of so-called
“income-led growth”, which was supposed to promote higher
economic growth through an increase in the households’
incomes (probably wages).
• Can it lead to growth in an an economy like Korea where
domestic market is small? Generally income-led (or wage-led)
growth is not suitable for an open economy.
 40
45
50
55
60
65
70
75
80
85
90

1990
1991
1992
1993
1994
1995
1996

Source: World Bank

1997

KOR
1998
1999
2000

JPN
2001
2002
2003
2004
CHN

2005
2006
2007
USA

2008
2009
2010
2011
DEU

2012
2013
2014
2015
2016
2017
Consumption shares (% of GDP)

27
3. Goals of Monetary Policy
• The goals of monetary policy defined in the act of central
bank
• -Price stability: inflation rate growing at less than 2%
• -Growth stability (or employment): need to distinguish
between trend and (business) cyclical
• -Financial stability: output loss (IMF world economic outlook)
 Price Stability

Output(Employ
Financial Stability
ment) Stability
Inflation Stability
• Inflation targeting is the monetary policy framework focusing
on inflation itself as the ultimate goal and aiming to achieve
its goal over the mid-term horizon.
• As inflation rates in most of countries are below the target,
however, central banks focused on addressing output or
employment stability.
Inflation Rate in Korea
Growth (Employment) Stability
• Which is the more appropriate measure reflecting the growth
mandate of central bank? Full employment or potential GDP?
• Full employment is more appropriate for the policy objective
of central bank i.e., macro-economic stabilization. This is
because a change in unemployment rate is completely
explained by the cyclical component of unemployment and
the natural rate of unemployment is fixed invariable.
• But the problem in Korea is that labor market is not sensitive
enough to business cycle and consequently is not much
affected by the monetary policy.
 Unemployment rates
Unemployment rate Youth unemployment rate
12
20

18
10
16

8 14

12

6 10

8
4
6

4
2
2

0
0
1991 1996 2001 2005 2010 2015 2017
1991 1996 2001 2005 2010 2015 2017
KOR JPN USA DEU
KOR JPN USA DEU

Source: World Bank

or

If natural rate of unemployment is unchanged in the short run,

we have

where as

𝑈𝑡 : Unemployment rate at time t

𝑈𝑓 : Natural rate of unemployment
𝑌𝑡 : Log GDP at time t
𝑌𝑓 : Log Potential GDP
34
• A change in GDP is composed of both the cyclical
component and the trend, which is the structural component.
• GDP is a second best alternative because it requires to
measure potential output, 𝑌𝑓 , which can be highly variable
and uncertain even in the short run, and to explain how
much changes in output are coming from the changes in
potential output.
Actual and natural rates of
unemployment in the US (Mishkin)
Actual and natural rates of
unemployment in Korea (OECD)
Trend and Cycle of U.S. Real GDP, 1947-
2004 (Barro, 2004)

The blue graph shows the logarithm of U.S. real GDP in The graph plots the difference between the log of real GDP and its trend.
trillions of 2000 dollars. The red curve is a The resulting series—the cyclical part of real GDP—shows the deviations
smooth trend drawn through the GDP data. of the log of real GDP from its trend. As an example, 0.02 means that real
GDP is 2% above its trend.
 Real GDP and Trend GDP in Korea
2.6

384 Trillion
2.5

2.4

2.3

2.2

2.1

2 101 Trillion
1990 1995 2000 2005 2010 2015 2017

LogGDP LogTrend

Note: Log of real and potential GDP (based on 2010). The slope means the growth of real and potential GDP
 GDP Gap in Korea
0.03

0.02

0.01

0
1990 1995 2000 2005 2010 2015 2017

-0.01

-0.02

-0.03

-0.04

Note: Difference between the logs of real GDP and potential GDP
Okun’s Law in the US and Korea
Real and Natural Interest Rates in Korea
Low Growth and Monetary Policy
• Is an insufficient accommodative monetary policy a cause of
lower growth?
• Very often lower growth rate is the result of lower potential
growth rate but when the economy is experiencing a lower
growth rate and slower recovery, this lower growth rate is
unduly considered as resulting from cyclical causes, increasing
pressures on central bank to adopt an excessively
expansionary monetary policy stance.
• Need to distinguish between monetary and structural policies.
 94.0
95.0
96.0
97.0
99.0

98.0
100.0
101.0
102.0
103.0

2001M01
2001M08
2002M03
2002M10
2003M05
2003M12
2004M07
2005M02
2005M09
2006M04
2006M11
2007M06
2008M01
2008M08
2009M03
2009M10
2010M05
2010M12
2011M07
Trend and Cycle in Korea after GFC

2012M02
2012M09
2013M04
2013M11
2014M06
2015M01
2015M08
Base Rate Cut in August 2014
• The Bank of Korea lowered its Base Rate by 0.25 of a
percentage point from 2.50% a year to 2.25% in August 2014.
• This step was taken on the ground that, together with the
expectation that upward price pressures would not be large
for some time to come, the persistent depression of
economic agents’ confidence in the wake of the Sewol ferry
accident could well hamper the future course of economic
recovery. (from Monetary Policy Report, September 2014)
• Justification: temporary shocks?
Bank Policy Rate
Financial Stability
• Some key stylized facts
• Typically, output does not recover to its pre-crisis trend. On
average, output falls steadily below its pre-crisis trend until
the third year after the crisis and does not rebound thereafter.
• The long-term output losses following banking crises are
substantial. Seven years after the crisis, output has declined
relative to trend by close to 10 percent on average.
• Medium-term growth rates tend to eventually return to the
pre-crisis rate but at a lower level.
• The recovery patterns are different across nations.
Output Loss due to Financial Crisis
Korea 1997
Short- and Long-term Income Losses in
Korea during the 2008 Global Financial
Crisis