Foreign Exchange Reserves and Inflation: An Empirical Study of Five East Asian Economies

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1 Th Empirical Economics Lrs, 8(5): (May 009) ISSN Forign Exchang Rsrvs and Inlaion: An Empirical Sudy o Fiv Eas Asian Economis Mi-Yin Lin * Dparmn o Economics, Shih Hsin Univrsiy, Taiwan Ju-Shyan Wang Dparmn o Public Financ, Naional Chngchi Univrsiy, Taiwan Absrac: This sudy xnds h im consisncy modl dvlopd by Kydland and Prsco (977) o incorpora xchang ra sabiliy in h policymakr's objcivs. W ind ha whn h orign xchang rsrvs incrass, h inlaion ra riss whil h xchang ra c is srong. Convrsly, h inlaion ra rducs whn h monary surpris c is mor powrul and h wigh placd on oupu sabiliy is no larg. Our mpirical sudy uss h daa or iv Eas Asian conomis o mak his argumn mor clar. Kywords: Forign Exchang Rsrvs, Inlaion, Tim Consisncy Modl JEL Classiicaion Numbr: E6; F3. Inroducion Th liraur on insiuional arrangmns or cnral banks has bn dvlopd ovr h pas svral yars. Th mos cid papr is prhaps h Kydland and Prsco (977) which has bn a spping-son or h subsqun works. In h prvious liraur, i is sandard o assum ha h cnral bank's objciv uncion involvs mploymn (or oupu) and inlaion wihin h conx o a closd conomy. Our sudy will xnd ino an opnconomy modl and highligh h rol o orign xchang in monary policy. Firs, h xchang ra will nr h objciv uncion, as do oupu and inlaion. This modiicaion innds o dscrib h ac ha many small or dvloping counris, lik Argnina or Mxico, hav mad xchang-ra sabiliy h cnrpic o hir inlaion sabilizaion amps. Today vn h Europan Monary Sysm (EMS) considrs ixd xchang ra as an advanag o orc govrnmns o pursu mor consrvaiv inlaion policis. Thror incorporaing xchang-ra sabiliy ino h objciv uncion is snsibl. And h similar sing can b sn in Obsld (996) and Vial (003). Furhrmor, bcaus h cnral bank uss orign xchang rsrvs as an insrumn o sriliz h xchang ra, w will spciy an quaion o rprsn h link bwn xchang ra and orign xchang rsrvs. Thror h chang in orign xchang rsrvs will ac h inlaion in h modl. Our mpirical sudy uss h daa or iv Eas Asian conomis o mak his argumn mor clar. * Corrsponding auhor. addrss:mylin@cc.shu.du.w.

2 Th Empirical Economics Lrs, 8(5): (May 009) 488. Thorical Framwork W spciy h Lucas-yp aggrga supply uncion wih h considraion o h c o n xpors. Th orm is: whr ( π π ) + β ( S + π π ) ε, > y = α + α > 0, β 0 () < y is h growh ra o aggrga oupu, π is inlaion ra, π is xpcd inlaion ra, π is inlaion ra o orign counry, S is h chang ra o xchang ra, andε is h shock o aggrga oupu. Th individual hav raional xpcaions and s π prior o h ralizaion o h oupu shock. In quaion (), wo acors conribu o h growh o oupu. Th irs rm, calld monary surpris c, dpics ha h aggrga oupu is a uncion o inlaion surpris. I h acual inlaion ra xcds h xpcd inlaion ra, ralizd ral wag will b lss han h lvl xpcd and h mploymn (oupu) will b rising. Th scond rm, calld xchang ra c, dscribs h impac o xchang ra on labor mark and oupu. Svral mpirical sudis hav ound saisically signiican cs o xchang ra or mploymn. In hory, an apprciaion o domsic currncy will rsul in lowr prics o orign goods. I rducs h dmand or domsic goods and in urn lads o lowr domsic oupu and lowr mploymn. On h ohr hand, Goldbry and Tracy (999) suggs ha in an xpor-orind indusry, an apprciaion o domsic currncy dircly rducs h compiivnss o is producs and lads o h dclin in labor dmand. Thror h c o an apprciaion has on mploymn is indrminabl. As shown by hs horis and mpirical rsuls, h sign o β in quaion () is ambiguous. Th cnral bank nds o inlunc h xchang ra by xchang mark opraions. Th inrvnion sragy is dscribd as: S = k FR, k > 0, () whr FR is h chang in orign xchang rsrvs. Th cnral bank should purchas orign currncy o l orign currncy apprcia; ha is k > 0. 3 Th xchang ra is dind as h domsic currncy pric o a uni o h orign currncy. S Burgss and Knr (996) and Gourinchas (999). 3 S h sam sing in Kohli (003).

3 Th Empirical Economics Lrs, 8(5): (May 009) 489 Th loss uncion o h cnral bank is givn in h ollowing quadraic orm: γ (,, ) γ L π ( ) y S = π + y y + S γ > 0, γ > 0, (3) whr y is h argd growh ra o oupu. Th paramr γ and γ masur h imporanc o sabiliy on oupu growh and xchang ra rlaiv o inlaion. Subsiuing quaion () and quaion () ino quaion (3), h policymakr's opimizaion problm is o choos h inlaion ra ha minimizs h loss uncion. By h irs ordr condiion, w obain: ( ) y ( k FR ) γ α β [ απ + β + π ε ] π = + γ ( α β) By h assumpion o raional xpcaions, h quilibrium inlaion xpcaion π = E π and E ε 0 yild: = ( ) y ( k FR + ) γ α β [ β π ] ε ( ) βγ ( α β ) + γ ( α β) π = γ α β Dirniaion o quaion (5) shows ha: π FR = ( α β ) βγ k βγ ( α β ) Th sign o h dirniaion rprsnd in quaion (6) is indrminabl bcaus h sign o α β is ambiguous. W sill ry o inrpr i by simpl conomic inuiion. Th dprciaion o domsic currncy dircly incrass oupu growh. Thn h oupu volailiy could b os by h inlaion c indircly. Whn α = β, quaion (6) is zro. I mans ha h xchang ra c is quivaln o h monary surpris c. And i is inciv or h cnral bank o lowr h oupu growh by alring h inlaion ra. Whn α < β, h sign o quaion (6) is posiiv. I implis ha h xchang ra c dominas h monary surpris c and h cnral bank will incras h inlaion ra o lowr h oupu growh indircly. Whn α > β, h sign o quaion (6) will dpnd on h dgr o γ. Equaion (6) will b ngaiv whn γ <. I h β ( α β ) wigh placd on oupu sabiliy objcivs ( γ ) is no larg, h cnral bank should lowr h inlaion ra o rduc h oupu growh. Namly, h cnral bank would rahr subsiu h monary surpris c or h xchang ra c. Howvr, i h wigh placd on oupu sabiliy objcivs is larg nough, h inlaion ra should b rising o (4) (5) (6)

4 Th Empirical Economics Lrs, 8(5): (May 009) 490 lowr h oupu growh as h cas o 3. Empirical Framwork α < β 3.. Th Daa and Economric Mhodology Th sudy consiss o iv Eas Asian conomis: Japan (JPN) and our ``Tigrs" (Hong Kong (HK), Kora (KOR), Singapor (SNG) and Taiwan (TWN)). Th inlaion ra is masurd as h annual chang in Consumr Pric Indx (CPI). Th xchang ra is dind as h domsic currncy pric o a uni o h U.S. dollar. Th inlaion ra o orign counry is h CPI inlaion ra o U.S. All h daa ar quarrly and span rom 98Q o 003Q4, xcp rom 994Q o 003Q4 or Hong Kong. Th daa s is obaind rom h Inrnaional Monary Fund s Inrnaional Financial Saisics (IFS). For Taiwan, h daa is rom Financial Saisics Monhly Taiwan Disric, h cnral Bank o China. For h irs viw o h daa, w compu h corrlaion coicin bwn inlaion ra (π) and orign xchang rsrvs: or Japan, 0.6 or Hong Kong, or Kora, 0.55 or Singapor, and or Taiwan. W suggs a rgrssion modl moivad by quaion (5) as h ollowing orm: π = β + β Trnd + β FR + β π + (7) 0 3 whr Trnd is im rnd, is h disurbanc rm. FR is h chang ra o orign xchang rsrvs. Th sign o simad coicin β can ll us h rlaion bwn inlaion ra and h orign xchang rsrvs. Th rgrssion can b simad or ach conomy rspcivly or as a sysm o spara quaions or h individual conomy. W assum h disurbancs ar indpndn across quaions whn h rgrssions ar simad by h irs mhod. Howvr, h scond mhod known as sming unrlad rgrssions (SUR) is allowing h disurbancs across quaions o b rly corrlad. 3.. Empirical Rsuls Firs, w sima quaion (7) or ach conomy rspcivly and his rgrssion is namd or Cas. Th mpirical rsuls ar rpord in Tabl. Th inlaion ra in Japan has signiicanly ngaiv rnd and h rnd rms in ohr our conomis ar no obvious. Th inlaion ra o U.S. is posiivly rlad o h domsic inlaion ra in ach conomy. Th coicin on FR is dirn among hs iv conomis. For Japan, on an avrag a % ris in orign xchang rsrvs lads o a % all in inlaion ra. Howvr, on an avrag a % ris in orign xchang rsrvs rsuls in a % ris in

5 Th Empirical Economics Lrs, 8(5): (May 009) 49 inlaion ra o Kora and a % ris in inlaion ra o Taiwan. This rlaion is signiican or Japan, Kora and Taiwan. Similarly, on an avrag a % ris in orign xchang rsrvs invoks an inlaion rspons o approximaly % or Hong Kong, % or Singapor. This rlaion is insigniican in hs wo conomis. Tabl : Esimad Rsuls o Equaion (7) in ach Economy Rspcivly (Cas ) Variabl JPN HK KOR SNG TWN Consan.394** Trnd * FR ** * ** π ρ R 0.8* * 0.785* * 0.98* 0.798* 0.789* 0.879* Obsrvaions No: Th rgrssions ar simad wih a corrcion or srial corrlaion by Cochran-Orcu mhod. *(**) indicas signiican a 5%(0%). Equaion (7) can also b simad as a sysm o spara quaions or h individual conomy. W us gnralizd las squars (GLS) o sima his sysm. Th sandard rrors ar compud rom hroscdasic-consisn marix dvlopd by Whi. Bcaus h sampl priod or Hong Kong is no as long as ohr our conomis, w sima his sysm by wo priods o analysis: Cas is rom 98Q o 003Q4 or our conomis xcluding Hong Kong, and Cas 3 is rom 994Q o 003Q4 or all iv conomis. Th rsuls ar prsnd in Tabl and Tabl 3 rspcivly. Tabl shows ha h sign o coicin on FR is ngaiv or Japan and is posiiv or Kora. Boh ar signiicanly dirn rom zro. Th rsul o Cas is xacly h sam as Cas. Howvr, h coicin on FR is no signiican in Singapor and Taiwan. Finding o Tabl 3 indicas ha h sign o coicin on FR is signiicanly posiiv or Kora and Taiwan which is similar o h rsul in Cas. For Japan, Hong Kong and Kora, h coicin is insigniican, nvrhlss. To sum up, h coicin on FR is signiicanly posiiv or Kora in hr cass. And h valu o h coicin rvals ha on an avrag a % ris in orign xchang rsrvs invoks an inlaion rspons o approximaly % o 0.00%. Th sign is signiicanly ngaiv or Japan and h signiicanc is wak in Cas 3. For hos

6 Th Empirical Economics Lrs, 8(5): (May 009) 49 signiican cass, an avrag a % ris in orign xchang rsrvs lads o abou % o 0.030% all in inlaion ra. For Taiwan, an avrag a % ris in orign xchang rsrvs rsuls in abou % o 0.063% ris and his posiiv rlaion disappars in Cas. And his rlaion is no vidn in Hong Kong and Singapor. Tabl : Esimad Rsuls o Equaion (8) by SUR: 98Q o 003Q4 (Cas ) Variabl JPN KOR SNG TWN Consan.844* * -.37* * Trnd -0.05* 0.038* 0.009* FR * 0.00* π R *.775* *.657* Obsrvaions No: *(**) indicas signiican a 5%(0%). Th signiicanc and magniud o h coicin on FR ar no robus o h sampl priod or h simaion mhod. Th main conclusion is ha h monary surpris c is srong in Japan. And h xchang ra c may b powrul in Kora and Taiwan probably. Ths wo cs ar approximaly quivaln in Hong Kong and Singapor. Tabl 3: Esimad Rsuls o Equaion (8) by SUR: 994Q 003Q4 (Cas 3) Variabl JPN HK KOR SNG TWN Consan * 33.6*.56* 3.57* 0.683* Trnd * * * * -0.38* FR * * π ** * 0.658* R Obsrvaions No: *(**) indicas signiican a 5%(0%). Th rsuls could b inrprd by h srucur o ach conomy. For h priod 986 o 003, h avrag rad dpndncy raio 4 is 6.5% or Japan, 55.9% or Kora, 8.83% 4 Th raio is masurd as h ra o sum o xpor and impor o GDP.

7 Th Empirical Economics Lrs, 8(5): (May 009) 493 or Taiwan, 86.08% or Singapor, and 3.0% or Hong Kong. W argu in Japan h impac o inrnaional rad on oupu may no b as srong as h domsic monary c. Howvr, Kora and Taiwan ar boh small opn conomis whr h inrnaional rad will play vry imporan rol in conomic growh. Thus h xchang ra c should domina h domsic monary surpris c. By h mpirical rsul, w conclud hs wo orcs ar approximaly balancd in Hong Kong and Singapor. 4. Conclusion This sudy is an xnsion o h im consisncy modl. Through h opraions in h orign xchang mark by cnral bank, w ar hn abl o analyz h rlaion bwn orign xchang rsrvs and inlaion ra. Th conclusion is ha whn h orign xchang rsrvs incrass, h inlaion riss whil h xchang ra c is srongr han monary surpris c. And h inlaion ra rducs whn h monary surpris c is powrul i h wigh placd on oupu sabiliy is no larg. W us h daa or iv Eas Asian conomis o mak our argumn mor clar. Th mpirical rsul shows ha h rlaion bwn h chang in orign xchang rsrvs and inlaion ra is ngaiv or Japan and is posiiv or Kora and Taiwan. And his rlaion is insigniican or Hong Kong and Singapor. W conclud ha h monary surpris c is srong in Japan and h xchang ra c is powrul in Kora and Taiwan. Ths wo cs ar approximaly quivaln in Hong Kong and Singapor. Rrnc Burgss, S. and M. M. Knr, 996, An Inrnaional Comparison o Employmn Adjusmn o Exchang Ra Flucuaions, NBER Working Papr 586. Goldbrg, L. and J. Tracy, 999, Exchang Ras and Local Labor Marks, NBER Working Papr Gourinchas, P.-O., 999, Exchang Ras Do Mar: Frnch Job Rallocaion and Exchang Ra Turbulnc, , Europan Economic Rviw, 43, Kohli, R., 003, Ral Exchang Ra Sabilisaion and Managd Floaing: Exchang Ra Policy in India, , Journal o Asian Economics, 4, Kydland, F. E., and E. C. Prsco, 977, Ruls Rahr han Discrion: h Inconsisncy o Opimal Plans, Journal o Poliical Economy, 85(3), Obsld, M., 996, Modls o Currncy Criss wih Sl-ulilling Faurs, Europan Economic Rviw, 40, Vial, P., 003, Forign Exchang Inrvnion: How o Signal Policy Objcivs and Sabilis h Economy, Journal o Monary Economics, 50,