Silviase/jgov_v1.4_full_ann huggingface dataset:
functional formal financial system may improve the efficiency of an economy. Follow up studies have come out recently from the staff of the IMF, such as Tseng and Corker (1991) and Hamann (1993). As is indicated in Page (1993), the monetary policy of developing countries, particularly low-income developing countries, has not been paid attention to for a long time because the importance of real sector developments made development of the financial sector or the monetary policy take second place in the concern of the policy-makers and scholars, so monetary policy was being ignored.

In view of the growing importance of macroeconomic management, we have attempted to investigate monetary policy, which is an essential element of macroeconomic policy. In this paper, we focused on the monetary policy of four Asian countries, Japan, Korea, Indonesia, and the Philippines, to examine the targets, effectiveness and the results of their monetary policies. Due to the lack of the quarterly economic statistics, we were not able to pick up fast-growing countries such as Thailand and Malaysia. In addition, Taiwan remains an interesting candidate for our future study. The periods we have chosen are different for each country, due basically to the availability of the time series data.

The countries we have studied represent the varieties of Asian nations. Japan, of course, a developed country in the region which lacks natural resources, is positioned as a benchmark of the study. Korea is representative of fast-growing NIEs, which lacks natural resources and has been developed by high growth of exports with heavy government intervention. Indonesia, on the other hand, is a representative case of a developing country which depends heavily on oil production but is attempting to free itself from the heavy dependence on oil production. The Philippines, which is typical of developing countries which are basically agricultural with the endowment of several mineral products, has a development strategy of industrialization by “import substitution.” Also, the Philippines is the only country in East Asia which fell into debt crisis.

In this study, we will focus on the targets, effectiveness and the results of the monetary policy of Japan, Korea, Indonesia and the Philippines in the light of macroeconomic policy, basically in the period of 1970's and 1980's.

Regarding the financial conditions, all the countries we studied changed in the 1980's. Financial and banking sectors of all four countries, including Japan, were strongly regulated by the authorities until that time. Strong rationing of subsidized credits existed in Korea, Indonesia and the Philippines until the late 1970's. Entering into the 1980's, all countries initiated deregulation and liberalization in the financial markets and the banking sectors.
This study attempts to clarify the following questions on monetary policy. What are the targets of the monetary policy? Is there a base of for the monetary policy to function effectively? Did the monetary policy have a real effect on the macroeconomic conditions? $ ^{4} $

One interesting topic of studying monetary policy is to find common factors affecting real economic performance and to derive policy implications. However, it is extremely difficult to connect monetary policy with actual economic performance. A recent detailed study by Tseng and Corker (1991) on the financial liberalization and monetary policies of Asian countries also faced the same problem. In our study, we have tried to explore the effectiveness of monetary policy and its relationship to macroeconomic performance.

We also are interested in the differences among the countries we have chosen for our study. Are there features of monetary policy common to all these countries or are they significantly different? To tackle these questions, this study estimated reaction function, money demand function, and applied VAR model.

In Chapter 1, we overview macroeconomic developments and financial developments of the four countries.

In Chapter 2, the analysis by reaction function indicates the target of monetary policy. It must be noted that this analysis strongly assumes that the tools we have chosen, discount rate and money supply, are econometrically exogenous variables which monetary authorities were able to control. Another strong assumption of this analysis is that monetary authorities are able to observe contemporaneous macroeconomic variables and that their responses can be made within one period. Under these two assumptions, we are able to observe targets of the monetary policy in a simple way.

Chapter 3 examines money demand function as the background of the effectiveness of the monetary policy. In formulating monetary policy, stability of relationship between money demand, interest rate and income is the crucial factor. If the money demand function does not perform properly, monetary policy may be ineffective. Also, a study of unit root and error correction model on money demand function has been attempted in Appendix 1.

Chapter 4, VAR analysis is applied to examine whether money in an
exogenous variable or not, and to determine the results of the monetary policy. The four variables used are growth of money supply, real economic growth rate, rate of inflation, and interest rate. If one variable can be identified as an exogenous variable from the variance decomposition based on Cholesky decomposition, we defined this variable as operational, which is a policy variable. Application of this analysis enables us to picture the causality between economic variables, and if these policy variables have some-kind of effect on other macroeconomic variables, we interpreted that "fine tuning" type of macroeconomic policy were implemented. Summary and findings of the study are mentioned in the final chapter.

In Appendix 2, we tried an individual study of foreign exchange rate policy, with an alternative data set, by applying response function and VAR analysis.

Although analyses attempted in each chapter do not have direct relationships between them, and they are under different assumptions; we will attempt to evaluate the monetary policy of four countries, from the conclusions of each study. $ ^{5} $
### Chapter 1. Macroeconomic and Financial Developments of Japan, Korea, Indonesia and the Philippines

1.1 International economic environment in the 1970's and the 1980's $ ^{1} $

The global economy grew rapidly in the 1960's, and Asian counties benefited from the favorable international economic environment. Rapid growth was the result of the free trade under the IMF and GATT regime, and the U.S. economy provided strong demand for exports. Also, Asian NIEs and ASEAN were affected positively by the special procurement boom of the Vietnam War in the middle of 1960's to early 1970's. Accordingly, the 1960's was an era of high growth.

In the 1970's, the framework of international economy was changed drastically by the collapse of the Bretton Woods regime in 1973, and the adoption of a flexible exchange rate system by the major industrial countries. The change of the exchange rate regime also influenced economic management of the Asian countries.

Another factor which had significant impact on the world economy was the two oil shocks during the 1970's. The upswing of oil prices negatively affected oil importing countries such as Japan, Korea and the Philippines, who faced deterioration of balance of payments, high inflationary pressure, and strong negative effects on economic growth. Indonesia, as an oil exporting country, benefited from the rise of oil prices.

However, the after-effects of the two oil shocks on the global economy were different. Soon after the first oil shock, major industrial countries adopted expansive economic policies to cope with the recession caused by the oil shock and the global economy recovered. Furthermore, the increased prices of the primary commodities benefited exporters of such products and many non-oil exporting developing countries recovered very quickly from the negative effects of the oil shock.

Remarkably, after the first oil shock, “recycling of oil money” proceeded smoothly through the Euro-market, which eased the balance of payment difficulties of many developed countries as well as developing countries. However, the easy funding from the Euro-market enabled developing countries to choose expansive rather than stringent economic policies. In Asia, Indonesia, Korea, Malaysia and the Philippines borrowed heavily from the commercial banks through the Euro-market. Latin American countries in particular pursued this policy.

However, after the second oil shock, the economic policies of the major industrial
countries were different from those adopted after the first oil shock. Instead of avoiding recession, economic policies of the major industrial countries took stringent fiscal and tight monetary measures to avoid inflation. With the results of high international interest rates and a global recession which negatively affected developing economies, particularly those of heavily indebted countries. Latin American and Asian countries struggled to make their external payments, and many countries, particularly Latin American countries, fell into debt crisis.

For many developing countries, the first half of the 1980's was a difficult period. The Philippines was in the process of adjustment to the economic crisis which occurred in the early 1980's, but it fell into debt crisis in 1983. After the balance of payments crisis, Korea faced low growth and was in a period of adjustment process in the early 1980's. However, after 1985, Korea benefited from the depreciation of the US dollar, low oil prices and the low international interest rates. Korean economic growth recovered as the exports grew rapidly, and accomplished high growth, finally turning its current account into surplus in 1986. Indonesia was also in difficulty in the early 1980's from the decline of oil prices and high interest rates, but overcame this problem. Macroeconomic policies were important components of the adjustment policies in this recovery process, particularly monetary policy. Indonesia, heavily depending on oil exports and indebted by external borrowing, also had difficulty and took measures to avoid debt crisis.

With the international economic environment, we will outline the economic development and the financial systems of the four countries in this chapter. We will also summarize the characteristics of financial systems of Japan, Korea, Indonesia and the Philippines to provide a background for our study of the monetary policy of these countries. The basic economic indicators of Japan, Korea, Indonesia and the Philippines are shown in Table 1-1 and Table 1-2. Trends of the main macro-economic variables are based on the quarterly data shown in Figures 1-9 through 1-20 at the end of this chapter.

### 1.2 JAPAN

(1) Macroeconomic development of the Japanese economy $ ^{2} $

The Japanese economy grew rapidly throughout the 1960's to the 1980's, as we can see in Figures 1-9, even through the growth rate declined in the 1970's to an average of 4%. The inflation rate was rather high in the 1970's, but relatively stabilized in the 1980's. The
current account balance was in surplus, except during the period of the two oil shocks of the 1970's.

This study divides the period into two parts. The first period is from 1962 to the first quarter of 1973, and second period is from the second quarter of 1973 until 1990, a division made because of the change in the exchange rate system. The first period is the fixed exchange rate system and second is the flexible exchange rate period. $ ^{3} $

Several large external shocks struck the Japanese economy in the early 1970's. The first was the end of Bretton Woods system in the summer of 1971: after the struggle to maintain the fixed exchange rate system by the Smithsonian Accord, the Yen rate floated from early 1973. $ ^{4} $ Another major external shock was the first oil shock in the late 1973, which quadrupled petroleum prices.

The early 1970's was a difficult period for the Japanese economy. Internally, in 1970's Japan was in a recession which was triggered by the decline of fixed and inventory investments in the late 1960's. On top of these domestic difficulties, appreciation of the Yen hit the Japanese economy. Attempts to sustain the exchange rate level agreed by the Smithsonian Accord of 308 yen per US dollar, and the government policy to stimulate the economy resulted in an extremely relaxed monetary policy. The growth of the money supply were extremely high in the early 1970's. When Japan was suffering from these difficulties and responding by stimulating the domestic economy, the first oil shock occurred. The rise of oil prices and the negative effects on the supply side produced stagflation of the economy. With an already expanded domestic money supply, Japan faced coexistence of inflation and stagnation of the economic growth and its economic performance of this period was the worst among OECD countries.

The Japanese economy was stabilized in the mid-1970's, and economic growth recovered gradually, but then the second oil shock hit in 1978. The global economy again suffered from the rise of oil prices and the after-effect of stagnation, although Japanese
economic performance was better than that of other countries. The characteristics of the Japanese economy in the first half of the 1980's were moderate growth, the undervalued yen rate causing accumulation of the trade surplus, and a low rate of inflation. In this period, serious bilateral trade friction developed between Japan and other developed countries. The trade imbalance between the industrial countries on one side, and the increasing current account surplus on the other, led to appreciation of the Yen in 1985 after the Plaza Accord.

The economic situation of Japan in the late 1980's did not come out as had been forecasted in 1985. Just after the Plaza Accord, the yen rate appreciated substantially and anxiety about possible recession was strong among Japanese the public and policy makers. The economic policy of this period can be characterized as a mixture of stringent fiscal policy and lax monetary policy. Due to the strong pressure to undertake fiscal reform, an expansive fiscal policy by the government was forestalled. Stimulation of domestic demand relied on the lax monetary policy of lowering the interest rate. Accompanied by this low rate of interest, inflation of asset prices, such as stocks and real estate stimulated rapid economic growth pulled by fixed investment and increasing consumption. In spite of anxiety about the prospect of a serious depression caused by the appreciation of the currency, the Japanese economy accomplished high economic growth from 1987 to 1990.

## (2) Characteristics of the Japanese Financial System

In this section, we will summarize the characteristics of the Japanese financial system. First, the financial system during the high-growth period will be described, and then financial liberalization and internationalization of the Japanese financial market will be examined.

Due to the difficult and severe constraints on the Japanese economy after World War II, reconstruction and economic growth were given first priority. Accordingly, the authorities imposed a wide range of restrictions on financial institutions and transactions. The financial sector of Japan, until the beginning of 1980's, was characterized by the predominance of indirect financing, over-lending, over-borrowing, mal-distribution of funds, interest rate regulation and strong segmentation of financial institutions.

In Japan, as in most developing countries, indirect finance, financing through the intermediation of banks, ruled throughout the high growth period. During the 1970's, the share of supply of funds by the banking sector accounted for more than 90%. Throughout this period, the banking sector relied excessively on borrowing from the Bank of Japan. This phenomenon, known as “Over-Loan,” is quite unique among the financial sectors of developed countries. In turn, the corporate sector depended heavily on borrowing from the banking sector. Two issues are associated with this state of affairs: the share of outside
funding was rather large; and due to the underdeveloped open capital market, the shares of security and bond financing remained relatively small.

In the interbank market, the city banks were constant borrowers, with the regional banks and other financial institutions being consistent lenders. Close ties between city banks and export-oriented corporations resulted in the concentration of loan demand on city banks. Under these circumstances, the inter-bank market rate, the call rate, was categorized as the market-determined interest rate in Japan during the high-growth era. Other interest rates, such as long-term and short-term lending rates and deposit rates, were in essence regulated interest rates. Moreover, the yields on public bonds were severely restrained.

There was ample segmentation among private banks. Most notably, financial institutions specializing in long-term finance were created to meet the need to finance capital investment in the high economic growth era. When Japan accepted IMF article VIII in 1964, limitations of foreign exchange transactions on current transactions were removed. However, the domestic financial market was strictly separated from the foreign financial market throughout the 1960's and 1970's. The domestic financial market was protected from external disturbances and competitions among financial institutions were inhibited. Heavy loan demands by export-oriented corporations were met mainly by city banks who were constant borrowers in the interbank market. However, this highly regulated financial system may deserve some credit for maintaining a very stable and sound financial system which facilitated industrialization and financed high export-led economic growth.

## (3) Financial Liberalization

Rather than sequentially tracing the process of the financial liberalization in details, we will highlight two central issues of this process: large-scale floatation of government bonds and internationalization of the financial markets.

Among several inducements to financial liberalization in Japan, the worldwide financial liberalization in the 1970's and 1980's affected Japanese financial markets. The emergence of substantial fiscal deficits played a decisive role in stimulating the development of an open capital market in the Japanese financial system. Another important factor in this process was undoubtedly the internationalization of Japanese financial markets.

The budget deficit of the central government grew rapidly after the early 1970's, because of the stagnation on of tax revenues on the one hand, and adoption of an expansionary fiscal policy to offset the slower economic growth after the first oil shock on the other. As a result, a considerable volume of government bonds were issued.
Figure 1-2 Ratio of M2/GNP (%): Japan

(Note) Ratio of end year monetary aggregates to the nominal GNP at the end of each year (Data Source) IMF IFS
The Bank of Japan kept purchasing a significant portion of the outstanding government bonds held by private banks. And therefore succeeded at persuading private banks to abstain from selling bonds in the secondary market. However, this ample float of government bonds stymied such policy, and consequently the capital market developed significantly, which naturally encouraged intense competition among financial institutions, thereby realizing succeeding financial innovations with essentially free market interest rates. The innovations were the newly introduced instruments of medium-term government bond funds, introduction of Certificate of the Deposits, introduction of MMCs and large-scale time deposits with free interest rates. The introduction of new financial instruments also affected the deregulation of the segmentation among financial institutions.

With the remarkably stable growth of the Japanese economy and the adaptation of the flexible exchange rate system, the Japanese financial markets became much more closely integrated with foreign markets, which made it difficult to sustain severe regulations on domestic financial markets. Hence in December 1980, New Foreign Exchange and Foreign Trade Control Law were enacted, permitting international capital transactions. Another important step was the announcement of the report of Yen-Dollar Ad-Hoc Committee, jointly established by the Japanese Ministry of Finance and the US Treasury, which further accelerated internationalization of the Japanese financial market.

As a result of these developments, many of the traditional characteristics of the Japanese financial system were diminished or at least considerably weakened. For example, the complete liberalization of interest rates has been accomplished and significant measures for deregulation of segmentation of the financial institutions have been taken. Although substantial unsettled problems remain, further financial reforms will be unavoidable as well as irreversible.

In the course of Japanese financial development since the 1960's, the Ml/GNP ratio fluctuated around 30%, but the M2/GNP ratio increased from 67% in 1962, to 90% in 1972. Since the beginning of 1970, the M2/GNP ratio did not grow very fast and we had to wait until 1986 for this ratio to exceed 100%. This slowdown of the M2/GNP is suggesting the development of alternative financial assets, however, it is high compared to other countries in our study, and indicates Japan's developed financial sector (Figure 1-1, Figure 1-2). $ ^{5} $
### 1.3 Korea

(1) Macroeconomic development of the Korean economy $ ^{6} $

The rapid economic growth of Korea since 1960's was one of the most remarkable results of post World War II economic development. After the Korean war, recovery in the 1950's from the devastation of the war was rather modest. The Korean economy accomplished rapid economic growth led by a rapid export growth in the 1960's, but faced a difficult situation in the early 1970's. The fast economic growth in the 1960's induced a rise in real wages, and as a result, Korean exporters were losing competitiveness in labor-intensive sectors. In response, the Korean government initiated promotion of heavy industries. The promotion was strongly supported by the government using preferential credit through governmental financial institutions and direct subsidies, a strategy called “the Big Push.” $ ^{7} $

Just after the Korean government started “the Big Push,” Korea faced the first oil shock in 1973. Higher oil prices and the following recession negatively affected the Korean economy. Low growth of exports caused by the worldwide recession slowed the economic growth, and the rise of oil and other import prices made a major contribution to the deterioration of the balance of payments. The acceleration of the inflation in this period had various causes, among them, a domestic inflationary pressure due to increased wages for skilled labor in the early 1970’s, and imported inflation due to rise of oil prices. Korean authorities undertook to contain inflation by fixing a nominal exchange rate from December 1974. Due to the high domestic inflation, the real exchange rate appreciated, which retarded exports. Despite these difficulties, government maintained “the Big Push” strategy which was enabled by the external financing.

This “Growth cum debt” policy succeeded during the 1970’s due to the fast recovery of the world economy in mid-decade. Increase of export receipts and workers’ remittances from the Middle East improved the balance of payments, and in 1977, the current account balance turned into surplus.

Credit can be given to the consistent government commitment to economic growth as one factor of the success of Korean economic development. In contrast to the growth under these favorable conditions in the mid-1970's, the Korean economy faced a difficult situation late in the decade. During the rapid economic growth throughout the 1960's and 1970's, Korean economy accumulated internal structural problems. Rapid change of the industrial structure toward heavy industry induced heavy demand for imported capital goods.