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Economic development and inflation: Lessons from the Korean experience
Economic Development and Inflation: Lessons from the Korean Experience HYUNG YOON BYUN
Economists continue to debate if inflation is a necessary corollary to an economic strategy for rapid development. This paper draws upon the experience of Korea since 1962 when Korea embarked upon an accelerated economic development plan. The GNP of Korea has grown rapidly at the annual average rate of 8.7 percent from 1962 to 199 1. The five phases of inflation in Korea are: (1) Inflation at the Outset of Development Planning; (2) Formation of Inflationary Structure; (3) Deepening of Inflation; (4) Stabilization of Inflation, and (5) recent resurgence of inflation. The paper discusses several specific issues in this context. (a) Money Supply and Inflation; (b) Cost-Push Factors and Inflation; (c) Inevitability of Growth-derived Inflation; and (d) Inflation and Income Distribution in Korea. (JEL: 0.11,0.21,0.53, E.31)
elected to embark upon an era of rapid economic growth in the early 1960s. The GNP of Korea has grown rapidly at the annual average rate of 8.7 percent from 1962 to 199 1. Concurrently, the socio-economic structure changed greatly. One of the many problems in the pursuit of rapid economic growth has been persistent inflation, which has resulted in the inequality of income distribution, excessive financial speculation, and economic instability in general. Some economists argue that inflation is an inevitable by-product, indeed an unavoidable cost, of rapid economic growth. The strategy of Korean economic development is characterized by four facetsrapid growth-orientation, industrialization, export-drive, and high dependency on an industrial sector dominated by large firms with oligopolistic powers. Economic growth is treated as equivalent to economic development with little consideration of resulting socio-economic consequences. To pursue rapid growth, the Korean government invested resources in some specific sectors, contributing to export promotion. Industrialization was also pursued by promoting big firms. Although the Korean economy achieved rapid growth following this development strategy, it suffered from serious structural adjustment problems-high dependency on foreign or external factors, deepening imbalance between Korea
Hyung Yoon Byun KDWI Journal
.
Seoul National University, College of Social Sciences. Department of Economics. Seoul 151-742, South
of Asian Economics,
Vol 4, No. 2.1993, pp. 3 13-330.
Copyright 0 1993 by JAI Press, Inc.
ISSN: 1049-0078
All rights of reproduction in any form reserved.
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agricultural and manufacturing sectors, and the concentration of economic power in the hands of a few. These problems became major factors in forming an inflationary core in Korea’s economic structure. The new industrial sector, dependent on exogenous foreign factors and the monopolistic market structure, encouraged cost-push inflation, as the cost increases were instantly shifted to price increases. The slowdown of agriculture has also induced an increase in prices of agricultural products. Since inflation was regarded as a secondary issue, it was accepted as inevitable by-product of rapid growth strategy, as so vigorously pursued by the Korean government. This article is organized as follows. Section I presents the brief history of price changes in the process of Korean economic development since 1962. Section II examines the main issues with respect to inflation in Korea. A brief conclusion follows in section III.
I.
THE RECORDS
OF INFLATION’
The period from 1962 to the present is divided into five subperiods, reflecting the trend and feature of price movements. 1. 2.
1962-1964: 1965-1969:
3. 4. 5.
1970-198 1: 1982-1987: 198% :
high inflation relatively low inflation: formation of an inflationary core in the economic structure high inflation: deepening of inflation low inflation: stabilization of price level recurrence of inflation
Inflation at the Outset of Development Planning (19621964) Beginning in 1962, the government launched a series of five-year economic plans. Due to rapid growth-oriented strategy, the annual average GNP growth rate in this period was 8.3 percent, which was above the target rate. High rate of GNP growth, however, coincided with a high rate of inflation. For example, the wholesale price index (WPI) rose at an annual average rate of 27.5 percent in 1963 and 1964. Reasons of this high inflation rate can be explained as follows: First, the ratio of fiscal investment and loans was high (see Table l), which led to excessive liquidity. Second, as the supply capacity of the real sector was inadequate to absorb the growth in demand, the shortage of goods and inflation followed. Especially, the low productivity of agriculture induced an increase in agricultural product prices. Third, the 1964 devaluation of the Korean won, in the face of deficit in balance of payments after 1962, increased the prices of imported goods.’ In this respect, this period may be termed as the era of growth-derived inflation. An inflationary core caused by the rapid growth-oriented and unbalanced development strategy began to be manifest.
Economic Development and lnjlation
315
TABLE 1. Trends of Fiscal Investment and Loans in the 1960s (Unit: billion won) Year
Fiscal Investment and Loans (A)
Domestic Credit (B)
A/B
27.2 27.3 23.6 29.5 62.5 79.0
54.8 65.6 71.4 100.0 130.5 231.5 429.7 684.0 866.6
0.49 0.41 0.33 0.30 0.47 0.34 0.27 0.25 0.21
1962 1963 1964 1965 1966 1967 1968 1969 1970 Source:
117.6 175.5 184.3 KDI,
Four decades of Public
Finance
in Korea; The Bank of Korea,
Economic
Statistics
Yearbook.
Formation
of an Inflationary
Core in the Economic Structure (1965-1969)
During 19651969, prices were stable in comparison with those in the earlier stage of development. Consumer Price Index (CPI) and Wholesale Price Index (WPI) increased at an annual rate of 11.4 percent and 7.5 percent, respectively, between 1965-1969. These rates were fairly low compared to those of other periods, albeit they were higher than those in other advanced countries. Such relatively stable price level can be explained by several specific factors: (1) mitigation of excess demand by the development of manufacturing, (2) increase of imports, and (3) less foreign disturbances due to stable exchange rate and low international raw material prices. Although prices increased at a lower rate in this period, the price level maintained an upward movement. As rapid growth-oriented strategy continued, high growth rates of money and investment fueled the inflationary pressure. Internally, the relative price relations between agricultural and manufactured products changed, whereas the Korean price structure in general remained vulnerable to foreign factors. Moreover, Korea’s new industrial structure with domination of large oligopolistic firms much dependent on external factors, encouraged formation of a cost-push inflation core. Therefore, this period can be considered as one when the germination of an inflationary economic structure in Korea took place. Deepening of Inflation (1970-1981) It was in the 1970s that the Korean economy entered the stage of full-scale economic growth. At the same time, however, the Korean economy experienced a high rate of inflation. The WPI and CPI surged by 18.5 percent and 16.7 percent, respectively, on an annual average during 1970-1981. Inflation in the 1970s was characterized by cost-push factors, in contrast to 196Os, when inflation in Korea was mainly caused by demand-pull factors. Cost-push factors,
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Figure 1. Wholesale Prices Changes. (Rates of Changes from the Previous Year.)
such as the two oil shocks and other crucial domestic supply bottlenecks primarily contributed to inflation in this decade. A recession, in the beginning of the 1970s made firms more vulnerable to the cost-push factors that had remained latent until then. These factors were excessive investment in equipment, inefficient business management, high financial costs3 incurred by excessive borrowing in the credit market, and an increase in prices of imported raw materials due to the devaluation of the Korean won as a policy measure to cut down deficits in the balance of payments.
TABLE 2.
Balance of payments and Exchange Rate (Unit: millions US $. won/US $)
Year
Current Balance
Trade Balance
Exchange Rate’
1970 1971 1972 1973 1974 1975 1976 1977 1978 1979 1980
-622.5 -845.7 -371.2 -308.8 -2.022.7 -1J386.9 -313.6 12.3 -1,085.2 4.151.1 -5.320.7
-922.0 -1.045.9 -573.9 -566.0 -1,936.8 -1,671.4 -590.5 476.6 -1,780.8 -4,395.5 -4.384.1
316.70 373.20 398.90 397.50 484.00 484.00 484.00 484.00 484.00 484.00 659.90
Note:
Source:
‘Exchange rate is the Bank of Korea concentration base rate at the end of year. The Bank of Korea. Economic Statistics Yearbook.
Economic Development and inflation
TABLE 3.
Comparison
317
of Prices of Agricultural
and Non-Agricultural
Products
(Unit: %)
Agricultural Non-agricultural Source:
1972
1973
1974
197.5
1976
9.1 8.3
9.0 16.6
41.9 44.0
28.0 18.1
19.2 6.3
Economic Planning Board, Price Level and Living conditions, 1982
Especially, a sharp increase in prices of international raw materials including crude oil led to the general price surge in the 1970s. Figure 1 clearly shows that the prices of raw materials increased a lot faster than those of capital goods, or of consumer goods. However, if it had not been for the strategy of export-driven industrialization and rapid growth adopted by the Korean government, the influence of the oil shocks on the general price level could have been much smaller. The oil shocks had much more impact, because it brought about a bigger deficit in the balance of payments which prompted major devaluations of the won twice, first in 1974 and again in 1980 (see Table 2). These devaluations pushed up import prices and then general prices. The prices of agricultural and marine products also had shown a steep upward trend from the beginning of this period. At the turn of the decade of the 1960s the share of manufactured products in GNP became larger and agricultural output fell short of the demand due to increases in income and urbanization. This explains why the increase of agricultural price led to general price increase during this period (see Table 3). Stabilization
of Inflation
(19821987)
The price level in Korea became exceptionally stable from 1982 to 1987. During this period, the annual average increase of WPI and CPI rates were only 0.2 percent and 2.8 percent, respectively. Some argue that this stabilization could be mainly due to anti-inflationary policies, such as, tightened money supply and direct price control. However, these policies did not seem to be a major cause of stabilization, since the inflation rate of Korea was not any lower than that of other countries (see Table 4). Stabilization of international raw material prices, rather than the government’s anti-inflationary policy, was the principal contributory factor. This stabilized the prices of manufactured products, and then the general price level. The price stabilization in this period underscored the fact that the Korean economy had a high degree of dependency on foreign factors, truly exogenous to Korea and beyond the control of the Korean government. Another noticeable change could be found in the relative price between light and heavy industrial products. During 1971-1979, excepting 1974 and 1975 when impact of the first oil shock was severe, price increased at an annual rate of 2.3 percent for light industrial products and 4.9 percent for heavy industrial products. During 1982-
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318
TABLE 4.
International Comparison of Inflation Rates (19821987 on average) (Unit: %)
WPI CPI Note: Source:
Korea
U.S.
Japan
Taiwan
0.2 2.8
0.6 3.3
-3.3 1.4
-2.0 0.5
Singapore -3.1 0.7
‘The baseyear is 1985 (i.e., 1985 = 100). except for Taiwan (i.e., 1986 = 100) National Statistical Oftice., Major Economic Indicators Abroad.
1987, the pattern of price variation changed as the two prices increased at an annual rate of 1.2 percent and -0.8 percent, respectively. As cost-push factors came to be controlled, the price of noncompetitive goods became also stable. While the inflation rate of competitive goods was 1.1 percent, that of non-competitive ones was -0.8 percent. This was because the heavy industry sector with high capital intensity and high dependency on international raw material market enjoyed the non-competitive market conditions. Therefore, the drop of foreign costpush factors explains much of the stabilization of inflation during these six years. Recurrence
of Inflation
(198% )
From 1988, prices again started to rise very sharply. The CPI increased at the rate of 8.6 percent and 9.3 percent in 1990 and 1991, respectively. The recent inflation shows different features from the previous ones. First, the gap between WPI and CPI has widened. Both of these indices had previously moved in the same direction, although there had been a difference in their rates of increase. But recently the difference between CPI and WPI widened by a rapid rise in the CPI in comparison with the relatively stable WPI. Second, the service sector prices have risen higher than the prices of manufactured products.4 Also the relative prices within the manufactured products changed remarkably. The inflation in this period was mainly led by the price increases of manufactured products from relatively light, labor-intensive consumer goods industries, whereas the previous inflation was led by those of manufactured products of heavy industries, which were more capital-intensive, and which used more of intermediate goods.’ It is especially remarkable that the recent inflation has been unaffected by foreign factors. Inflation is mainly due to the increase in money supply and the speculative flow of funds caused by the influx of foreign exchange holdings, the rise of wages and service prices, and the increase in construction investment. The expansion of the domestic market and the changes in consumption expenditure explain recent inflation. The share of expenditure on durable goods in household consumption has increased sharply from 3 percent at the end of 1970s to 9.6 percent in 1990 (see Table 5). The change in the pattern of consumption also led to the price rise following increases in aggregate effective demand.
Economic Development and inflation
TABLE 5.
Composition
319
of Household Consumption
Expenditure
(Unit: o/o,constant price) 1986 1987 1988 1989 1990 Source:
Durable goods
Semi-durable goods
Non-durable goods
Services
6.8 8.2 8.8 9.1 9.6
9.1 9.6 9.7 9.6 9.5
47.8 46.9 46.1 45.6 45.0
35.1 35.3 35.4 35.1 35.9
The Bank of Korea, National Accounts.
Therefore, the wage rises and the changes in consumption pattern accompanied by income increases due to rapid economic growth are the important contributing factors to the recent inflation, generally reflecting changes in the demand structure. But we note that the cost-push inflation structure still exists, because the price stability of non-competitive and heavy industrial products is mainly due to the stability of the prices of international raw materials.
II.
MAIN ISSUES WITH RESPECT TO INFLATION
In this section we discuss several major issues connected with inflation. First, the relationships between inflation and money supply as well as cost-push factors are examined. Second, we examine whether inflation is inevitable to rapid economic growth. Third, the relationship between inflation and income distribution is investigated. Money Supply and Inflation Many studies (Hong 1990; Park 1982) on the relationship between money supply and inflation report empirical findings on a positive correlation between the two aggregates. Economists, however, disagree as to whether money supply is the most important determinant of inflation. The strict monetarist view that monetary expansion is necessarily the main cause of inflation is not verified in Korea. Looking at the movements of inflation rate and money growth rate during 1971-1991 (see Figure 2), we observe no close relation, even if lagged effects are taken into consideration. The reason for the scant support for the monetarist view is attributable to peculiar characteristics of the Korean economy. First, the extent of monetization has deepened, as the economy has been growing. As a result of monetization, income velocity of money has decreased since 1975 (see Figure 3). Second, and more importantly, there exist price rigidities in the Korean economy. The government has pursued a direct price control policy. It preferred a direct control of prices at the micro level, rather than an adjustment of macro variables via policies
JOURNAL OF ASIAN ECONOMICS, (4)2,1993 “V
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-1 m 71
72 73
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Figure 2.
77
78
79
80
81
82
83
64
85
66
87
88
89
90
91
Money Supply (M2) and Wholesale Price Changes. (Rates of Changes from the Previous Year.)
of demand management. In other words, demand changes initiated from the increase in money supply could not affect prices, because government directly controlled the price of major individual items including public utilities and necessities. Especially in the 197Os, the prices of major manufactured products and necessities were under the control of the government. Accordingly, price changes were sharply enforced by so-called “price realization” at a given time. Thus, prices moved in an irregular pattern rather than monotonously and smoothly. Another factor attributable to the price rigidity was the oligopolistic nature of the Korean industrial structure. By monopolistic pricing, some big firms tended to stick to the previous prices, even when cost decreased. GNP/M2
26
$0
71
72
73
74
75
76
77
Figure 3.
78
79
fX
81
62
83
84
Income Velocity of Money
85
86
87
88
89
w
321
Economic Development and lnflation
Third, the main objective of monetary policy was not price stabilization. In the 1970.3, monetary policy focused on the efficient allocation of the limited funds to promote some selected industrial sectors. Monetary control was carried out in a limited scope to absorb the excessive liquidity by credit increases. Thus, the target variable of monetary policy was the level of domestic credit in the 1970s because government wanted to effectively supply funds to the domestic sector to finance the enormous investment demand with limited exposure to international risks. Furthermore, it did not need to worry about the growth of Ml or M2, as long as the monetary target was domestic credit, enabling it to guarantee a constant amount of credit to domestic firms. This implies that price stability was not the main objective of the Korean monetary policy. Despite all these arguments against the monetarist view, money should be regarded as one of the important factors of inflation on the demand side. However, even in the 1970s and in the early 198Os, when the monetarist view was supported by the basic guideline of monetary policy, economic circumstances induced the monetary authorities to change the target rate of money growth quite frequently. Moreover, actual growth rates also deviated significantly from the target rates (see Table 6).
TABLE 6.
Target and Actual Rates of Main Monetary Aggregates (Unit: %)
Monetary Aggregate
Target Increase Rate
Actual Rate
Domestic Credit (MI) 1970 27.0 1971 PI 28.0 1972 * 24.0’ 1973 w 24.0 + 28.0 1974 v 33.7 1975 w 35.3 1976 w 26.1 + 23.8 (20 + 28) 1977 H 24.1 -24.7 (23-25) 1978 w 34.2 (30.3) Domestic Credit Mz(M1) 1979 25.0 (23.6) 1980 v 20.0 + 25.0(15+20) 1981 0 25.0(23.0) 1982 w 20-22 + 25( 18-20) 1983 ?P 18-20-+ 15 1984 w 11-13 1985 m 9.5 1986 m 12-14 + 16-18 1987 * 15-18 1988 0 15-18 Note:
‘Target
24.6 26.9 25.0 27.0 15.2 7.7 15.6 18.4 19.1 21.5
(20.7) (16.3) (4.6) (45.6)
Rate at the end of June
2Values in parenthesis indicate auxiliary Source:
28.0 31.1 30.4 31.7 54.2 32.2 21.7 (30.7) 23.6 (40.7) 45.9 (34.9)
target values
The Bank of Korea, Annual Report and Economic
Statistical
Year Book.
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In sum, it can be asserted that money supply did not directly affect the inflation in Korea, but had only an indirect effect on inflation by way of increasing demand pressure, such as government investment, domestic credit for firms, and foreign currency loans. 2.
Cost-Push Factors and Inflation
The past two decades in Korea witnessed cost increases as a major determinant of its high rate of inflation (Park 1992). The cost-push was originated from high corporate financial costs and the devaluation of the currency in the 1970s price increases of imported raw materials including crude oil, first in 1974 and again in 1980, and increases in wages since 1988. The distinctive feature of cost-push inflation in Korea is clearly shown when the WPI increase rates in Korea during the two oil shocks are compared with those in other countries (see Table 7). It tells us that the price in Korea responded more sensitively to the cost increase than that in other countries, as indicated by a rapid rise in WPI. Then, the question arises what was the structural feature to shift cost-push toward inflation in Korea. In the first place, it is Korea’s relatively high degree of dependency on the foreign factors. It contributed to the evolution of an inflationary core in the Korean economic structure in two aspects. One aspect is that domestic prices have been immediately influenced by foreign price changes due to Korea’s deep import-dependency. The average degree of import-dependency marked 12.9 percent across all industries in 1985, especially 21.7 percent in the case of manufacturing and 28.2 percent in heavy industry (see Table 8). Export-driven industrialization, which prompted the importation of raw materials and intermediate goods for exporting manufactured goods, rendered the industrial structure very much dependent on the foreign factors (see Table 9). At the same time, the import increase resulted in the external deficit and the decrease of foreign currency holdings. To correct this problem, the government adopted currency devaluation and import restrictions, which further acted to boost inflation.6 In this sense, export-driven growth could be achieved only along with the sacrifice of price stability. The co-movement between WPI and import price index over the past two decades mirrors this fact as Figure 4 indicates.
TABLE
7.
Increase
Rates of WPI During
Oil Shocks
(Unit: o/o) 1974 1980 Source:
Korea
U.S.
Japan
420 39.0
18.8
32.1 14.9
18.3
National Statistical Offices. Major Economic Indicators Abroad.
W. Germany 13.6 7.5
Taiwan 40.8 21.6
Singapore 20.0
Economic Dmelopment and Inflation
323
TABLE 8.
Import-Dependency
by Industry (Unit: %o)
1975 Agriculture, Forestry & Fishing Mining Manufacturing Light Industry Heavy Industry Services All Industries Now
Import-dependency
1980
2.4 4.0 21.9 13.6 33.8 3.3 12.8
1985
2.2 0.6 22.7 13.7 31.1 7.0 14.2
= (Input of intermediates importedfMa1
1.8 0.7 21.7 13.2 28.2 4.7 12.9
output) x 100
Source: The Bank of Korea, 1985 Input-Output Tables.
TABLE 9.
Composition
of Imported Goods (Unit: 700)
Intermediate Goods
Capital Goods
Consumption Goods
74.3 82.1 84.5
20.2 13.9 11.6
5.5 4.0 3.9
1975 1980 1985 Source:
’
-10’ 71
72
The Bank of Korea.1985
’
’
’
’
’
Input-OutputTables.
’
’
’
73 74 75 76 77 78 79 80
-
WPI
+
’
’
’
’
’
’
’
’
’
!
81 82 83 84 05 86 87 80 89 90 Import
prices
Figure 4. Wholesale Prices and Import Price Changes (Rate of Changes from the Previous Year)
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Figure 5.
78
79
80
Competitive
81
82
83
OF ASIAN ECONOMICS,
04
06
*.,..... Noncompetitive
86
07
80
89
90
(4)2,1993
91
1
Competitive and Non-competitive Commodity (Rate of Changes from the Previous Year)
Prices.
Second, the establishment of oligopolistic industrial structure and the unbalanced growth in industry further contributed to cost-push inflation. The industrializationoriented development strategy not only caused severe imbalance between agriculture and manufacturing, 7 but also changed the structure of relative prices between the agricultural and non-agricultural products.* As manufacturing became priority and thus relatively more important, changes in the price of manufactured products dominated movements in general prices.’ After the mid- 197Os, the prices of heavy and chemical industrial products have led general prices, and this has mainly been due to the price setting by a few big firms with oligopolistic power. The mark-up pricing policy of big firms has significantly contributed to price rises, because the price had downward-rigidity. Cost increases raised not only their own prices but also the prices of other products sequentially. Some evidence for the two reasons mentioned above is as follows: First, the ratio of sales costs to total sales exhibits more stability in big firms than in small and medium firms.” It might show that the mark-up ratio in the big firms stayed at a constant level. Second, considering the different pricing rule between the competitive and noncompetitive commodities, as is illustrated in Figure 5, we see that the price increase in a noncompetitive commodity was higher than that in a competitive commodity in 1972, 1974-1975 and 1980, when the international price of raw materials and the corporate financial costs rose. In addition to firms’ behavior, the government’s price policy contributed to uphold mark-up pricing. In 1975, the government adopted “Fair Trade Act” under which some producers were permitted to raise their prices following the rate of increase, as
Economic Development and Inflation
325
determined by the government. Under this scheme, the government approved the rate of increase for the pre-determined items by just adding some fixed mark-up ratio to cost data offered by the firms. This kind of direct price control made it possible for the firms to transfer cost increases to the consumers. This became very evident whenever firms were in serious trouble throughout the 197Os, during which the Korean economy experienced the two oil shocks.” 3.
Inevitability of Growth-Derived
Inflation
Some economists take the view that inflation is an inevitable consequence of economic growth, especially when the rate of growth is so rapid. That is, inflation in Korea has been a necessary evil to achieve rapid economic growth. Generally in underdeveloped countries, economic growth accompanies increases in investment demand to enhance production capacity which is financed through expansionary fiscal and monetary policies, as well as in consumption demand which is a result of growth in employment. However, as productivity of industry lags behind growth in demand, it spurts inflationary pressure. It follows that underdeveloped countries have to endure inflation, unless they abandon the goal of rapid growth. However, it is doubtful that inflation is indispensable in the process of rapid growth. On the contrary, inflation can impede economic growth.12 As a matter of fact, there were several sub-periods when economic growth and inflation did not go together (see Figure 6). Apart from the period of the oil shocks which showed severe stagflation, there were also periods when recession went handin-hand with inflation. It is to be noted that the price-level remained stable during some period of rapid growth, as in 1986 and 1987.13
-
GNP
growth
rate
+
CPI increase
rate
Figure 6. Economic Growth and Price Changes. (Rates of Changes from the Previous Year.)
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.a.’ . . .....
.
.... .. ..
. . . . . . . .q,
3’ ‘*., ‘Q,
I.,,
a..,
:
j
3:s
(Unemployment
Figure 7.
I
1
.~~~..~__..._..__....~............ .::
-90 ‘-+3 eq. .a
2:5
jz6j ._......,,..,. i __,. fri ‘1 ;: ! ; j.h72
(4)2,1993
i
415
rate, %)
5.6
Phillips Curve (1971-1990)
We may look at the relationship between the two from the point of view of the Phillips curve. But when we draw the Phillips curve of the Korean economy, it is hard to observe that the curve moves downward to the right (see Figure 7).14 The assertion that inflation is inevitable as a result of rapid growth can be refuted by comparing the inflation rate of Korea with that of Taiwan which recorded a comparable high rate of growth. During 1971-1990, the price-level of Taiwan was relatively stable, with an annual average increase rate of 6.9 percent for CPI and that of 4.8 percent for WPI, in contrast to the Korean rates of 11 .Opercent and 10.5 percent, respectively. Moreover, after 1974, the annual average growth rate of money (M2, period-end basis) in Taiwan was 22.2 percent, whereas that of Korea was 23.1 percent. It is remarkable that the gap of inflation rates between two countries was so visible, despite the small difference in their money supply growth rates. This implies that inflation in any one country does not simply depend upon the economic growth and money supply, but is strongly influenced by the industrial structure and economic development strategy.r5 The Korean government’s policy accelerated inflation under rapid economic growth. Throughout the period in the 1960s and 1970s government did not actively exercise the restraint over aggregate demand to curb inflation. The basic attitude of the government was, to a certain degree, to accept inflation, while alleviating its adverse side-effects. The government adopted a micro-level price policy, such as, price controls over specific goods or products of a specific sector, rather than a macro-level price policy for restraining aggregate demand, because government would not abandon the rapid growth strategy (see Table 10). Even in the 1980s rapid growth, not price stability, received higher priority in the Korean government’s policy. During the period of stagflation in the early 198Os, the government emphasized a policy of increasing exports to contain the situation. When
Economic Development and Inflation
TABLE 10. Time 1976.3 1977.5 1978.7 1979.2 1979.4 1979.12 1980.12 1981 1982 Source:
327
Trends in Government
Numbers of Items
Number of Firms
148 157 148 74 46 35 35 97 67
247 272 257 124 81 58 58 152 87
Time 1983 1984 1985 1986 1987 1988 1989 1990
Price Control Number of Items
Number of Firms
58 52 47 43 42 38 36 33
74 73 64 61 59 51 47 45
Economic Planning Board, Economic White Paper
the firms were in difficulties and the economy was in recession, the government took action to “realize” the prices of commodities, which enabled the firms to shift the increased costs to commodity prices. Indeed, direct control over price was the major device of the government’s price policy. It follows that inflation-control has been secondary in policy agenda. The government in implementing its economic growth policy has tacitly accepted the inflation. 4.
Inflation
and Income
Distribution
Inflation, which caused a discrepancy between nominal and real values, provided firms with favorable conditions for rapid growth by lessening its real financial cost and real wage cost. First, inflation alleviated the financial cost for firms which are mostly dependent on loans from the financial institutions by reducing the real interest rates. Table 11 presents real interest rates, and demonstrates that interest rates were kept low over the whole period. l6 For some years when real interest rates were negative, firms increased their real incomes by getting loans from the financial institutions. In particular, considering the fact that the interest rates on preferential loans were kept lower than those on general loans, and that the proportion of the preferential loan was very high,17 we easily recognize that low interest rates greatly reduced the financial costs of firms. Low interest rate was, however, a barrier in increasing domestic savings. Since the domestic investment ratio was higher than the domestic saving ratio, the monetary authorities increased money supply by borrowing from the Bank of Korea, which resulted in the inflationary pressure. Under this financial structure, the accelerated inflation rates stimulated firms to shift their financial costs to others.18 Second, inflation also provided firms with favorable conditions for overcoming the recessions as production costs were reduced by lowering the real wage rate. With regard to the relationship between wages and prices, the main point of discussion is the causality between the two variables. The wage-control policy during the early
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TABLE 11.
OF ASIAN ECONOMICS,
(4)2,1993
Real Interest Rates, Increase Rate of Real Wage, and Real Estate Prices (Unit: %) Real interest rate
1971 1972 1973 1974 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 Note:
Curb market Increase rate of Increase rate of Increase rate of real interest rate real wage house price land price
8.0 3.8 12.3 -8.8
36.4 27.3 30.3 16.3
8.6 4.2 8.1 11.0
36.7 14.6 14.9 17.6
-
-9.9 2.7 6.0 4.5 0.8 -8.7 -5.6 2.9 6.6 7.7-9.2 7.5-9.0 7.2-8.7 7.0-8.5 2.9-5.9 4.3-6.8 1.4-3.9
26.0 25.2 28.1 26.7 24.2 16.2 13.7 23.5 22.4 22.5 21.5 20.8 20.0 15.6 13.4 10.1
1.6 19.4 24.7 19.0 10.4 -6.0 -1.5 7.6 8.8 5.8 7.4 6.4 8.6 12.6 19.4 11.6
38.6 27.3 24.6 30.8 37.8 26.8 21.2 2.3 22.6 3.1 0.0 -3.0 5.3 15.6 17.5 16.7
27.0 26.6 33.5 49.0 16.6 11.1 7.5 5.3 18.5 13.2 7.0 7.3 11.2 27.2 32.8 20.0
‘real interest rate = interest rate on other bills - CPI growth rate *increase rate of real wage = increase rate of monthly ‘Curb
Source:
average nominal wage in manufacturing
- CPI growth rate
market real interest rate = curb market interest rate - CPI growth rate
Economic
Statistics Yearbook,
Statistical
Offices:
The Bank of Korea: Annual Report on the Family
Trends in Land Prices, Ministry
Income and Expenditure
Survey. National
of Contraction.
1980s could be justified by the argument that wages are one of the most important factors of inflation. But it has not been empirically demonstrated yet.” Due to inflation, firms could enjoy rapid growth by reducing production costs through the reduction of wage costs and financial costs, and also by shifting them to other sectors. In other words, inflation worsened income distribution by redistributing income in favor of firms.*’ Indeed, inflation had more influence on income distribution than what the estimated values may suggest. Because inflation were more beneficial to real asset holders, the accelerated inflation led to speculation in real assets as a good hedge against inflation. The two most popular assets for speculation in Korea are land and houses. Soaring real estate prices reflect heavy speculation in these assets (see Table 1 I), which widens the wealth inequality between asset holders and others. Furthermore, if we take into consideration the fact that the price of lands and houses is hardly included in
329
Economic Development and Inflation
calculating the price index, the real effects of inflation on income distribution be much greater than otherwise reported. III.
would
CONCLUSION
Inflation has been closely associated with the economic development strategy in Korea. This strategy is characterized by rapid growth-orientation-fast industrialization, export-driven, and big firms-centered industrial structure. The resultant industrial structure, a highly monopolistic and oligopolistic structure, is highly dependent on foreign factors, and has caused a serious decline of the agricultural sector. The external dependency of industrial structure generated a price structure in which domestic prices have remained highly sensitive to foreign price movements. In addition, the balance of payment deficits had induced the government to adopt currency devaluations and import restrictions, which further spurted inflation. The monopolistic and oligopolistic industrial structure gave rise to a price structure where cost increases are easily linked to price increases, resulting in consequential price increases of all other products. The slowdown of agriculture had been another factor adding to the inflationary pressure. Inflation in Korea is essentially cost-push and it originated from its economic growth strategy. Therefore, it cannot be justified that the inflation must be tolerated for rapid economic growth. In fact, the government gave top priority to rapid growth and took price stability as the secondary policy target. Inflation in Korea, however, did not originate from economic growth itself. So it is unacceptable that inflation must be tolerated for rapid growth. This can be supported by the fact that in Korea the correlation between GNP growth rate and inflation rate is not observed. Inflation in Korea worsened the income distribution by redistributing incomes in favor of large firms and stimulating speculations in land, house, and so on. In particular, the expansion of speculations due to inflation aggravated the inequality in income distribution. NOTES 1. For the values which are not specifically mentioned, see appendix tables, available on request from the author. 2. Government exercised devaluation from 130 won to 256 won per U.S. dollar in May 1964. 3. The adjustment of official interest rates to the market rates in 1965 contributed to lowering inflation rate and promoting savings. This measure, however, became responsible for not only the unhealthiness of financial institutions by the provision of negative spread of frequency, but the increase of corporate financial cost. 4. Service prices and the prices of manufactured products increased at the annual average rate of 8.3 percent and 4.6 percent, respectively, during the period of 1988-1991: 5. The annual price increase rates by sector during 1988-1991 is as follows. 1. light industrial products: 2.9 percent vs. heavy industrial products: 2.1 percent
JOURNAL
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2. intermediate goods: 1.3 percent vs. consumption goods: 6.0 percent 3. labor-intensive products: 7.7 percent vs. capital-intensive products: 1.4 percent. 6. In the 197Os, under a direct exchange control regime, the government used devaluation as a policy tool for achieving export promotion and the improvements in the external deficits. Each devaluation in 1970, 1974 and 1980 produced a rapid rise in domestic prices during the respective period, see Table 3. 7. Note that while the average growth rate of agriculture and fishing was 2.23 percent during the period of 1965-1990, that of manufacturing was 15.58 percent during the same period. 8. The price indexes for agricultural and manufactured products were 9.0 and 16.5 at the end of April 1970, but they were 108.3 and 157.8, respectively, at the end of December 1991. 9. From 1970 to 1990,72 percent of the general price changes can be explained by changes in the price of manufactured products, while 20.3 percent in the price of agricultural products. 10. Notice that the variance of sales costs to total sales ratios in the big firms and the small and medium firms were 0.38 and 0.58 during the period of 1975-1990. 11. For example, government raised the prices of oil and other products about 30 percent in December 1974, and 3 1.3 percent in December 1975. 12. SeeMeier(l976,p. 321 &pp. 311-315). 13. The relation between GNP growth rate and price increase rate is very suggestive. Calculating the cross correlation coefficients between annual GNP growth rate and annual GNP deflator growth rate during the period of 1971-1991, the correlation between them does not exist at the significance level of 5 percent. When GNP deflator growth rate is replaced with CPI growth rate or WPI growth rate, the result is the same. causality test also suggests the same. Analyzing quarterly GNP and GNP deflator data, we cannot find the causality between economic growth rate and inflation rate. 14. There has been no clear conclusion on the debate over the downwardness of the Phillips curve. But a recent study claims to demonstrate that the long run Phillips curve does not have a downward slope. See Jun (1991). 15. According to one study, despite high monetary growth, Taiwan was able to maintain a lower rate of inflation, because the increase in demand for money in Taiwan resulted from the difference in industrial structure and increased desire of people to hold money as a instrument of savings. See Korea Economic Research Institute (1986). 16. Owing to the regulation, bank interest rate is very different from the market interest rate as is represented by the curb market interest rate, see Table 11. 17. The gap between interest rates on preferential loans and those of general loans widened as much as 18 percentage points, and the proportion of preferential loans among new loans extended generally remained at about 50 percent. 18. There is a counter argument that it is a high interest rate policy that causes inflation. According to Taylor, the increase in the interest rate is a source of inflation due to the fact that it reduces aggregate supply rather than aggregate demand in underdeveloped countries, and hence low interest rate policy is more appropriate for price stabilization in the case of underdeveloped countries. See Taylor (1991). 19. Most researchers conclude that there is a mutual causation between wages and prices. 20. Gini’s coefficients and multiples increased when prices rose high.
REFERENCES Hong, Kap-Soo.
1990. “On the Relations of Inflation to Wages, Money Supply and Growth in Korea.”
Monthly Bulletin (Bank of Korea),
Jun, Sung-In. Economic
44(5):
41-64.
1991. “Comparative Study on Models for Estimating Outlook, 10( 1): 95-l 18.
Nominal Wages,” KDI Quarterly
Economic Development and Inflation
331
Korea Economic Research Institute. 1986. Monetary Policies and Prices of Korea and Taiwan, Seoul. Meier, Gerald M. (ed.). 1976. Leading Issues in Economic Development, New York: Oxford University Press. Park, Kwang-Min. 1992. “Characteristics and Determinants of Recent Inflation in Korea.” Monthly Bulletin (Bank of Korea), 46( 10): 3-27. Taylor, Lance. 1991. Income Distribution, Inflation and Growth, Cambridge, Mass.: MIT Press.
Received November
1992; Revised May 1993
Economists continue to debate if inflation is a necessary corollary to an economic strategy for rapid development. This paper draws upon the experience of Korea since 1962 when Korea embarked upon an accelerated economic development plan. The GNP of Korea has grown rapidly at the annual average rate of 8.7 percent from 1962 to 199 1. The five phases of inflation in Korea are: (1) Inflation at the Outset of Development Planning; (2) Formation of Inflationary Structure; (3) Deepening of Inflation; (4) Stabilization of Inflation, and (5) recent resurgence of inflation. The paper discusses several specific issues in this context. (a) Money Supply and Inflation; (b) Cost-Push Factors and Inflation; (c) Inevitability of Growth-derived Inflation; and (d) Inflation and Income Distribution in Korea. (JEL: 0.11,0.21,0.53, E.31)
elected to embark upon an era of rapid economic growth in the early 1960s. The GNP of Korea has grown rapidly at the annual average rate of 8.7 percent from 1962 to 199 1. Concurrently, the socio-economic structure changed greatly. One of the many problems in the pursuit of rapid economic growth has been persistent inflation, which has resulted in the inequality of income distribution, excessive financial speculation, and economic instability in general. Some economists argue that inflation is an inevitable by-product, indeed an unavoidable cost, of rapid economic growth. The strategy of Korean economic development is characterized by four facetsrapid growth-orientation, industrialization, export-drive, and high dependency on an industrial sector dominated by large firms with oligopolistic powers. Economic growth is treated as equivalent to economic development with little consideration of resulting socio-economic consequences. To pursue rapid growth, the Korean government invested resources in some specific sectors, contributing to export promotion. Industrialization was also pursued by promoting big firms. Although the Korean economy achieved rapid growth following this development strategy, it suffered from serious structural adjustment problems-high dependency on foreign or external factors, deepening imbalance between Korea
Hyung Yoon Byun KDWI Journal
.
Seoul National University, College of Social Sciences. Department of Economics. Seoul 151-742, South
of Asian Economics,
Vol 4, No. 2.1993, pp. 3 13-330.
Copyright 0 1993 by JAI Press, Inc.
ISSN: 1049-0078
All rights of reproduction in any form reserved.
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JOURNAL OF ASIAN ECONOMICS, (4)2,1993
agricultural and manufacturing sectors, and the concentration of economic power in the hands of a few. These problems became major factors in forming an inflationary core in Korea’s economic structure. The new industrial sector, dependent on exogenous foreign factors and the monopolistic market structure, encouraged cost-push inflation, as the cost increases were instantly shifted to price increases. The slowdown of agriculture has also induced an increase in prices of agricultural products. Since inflation was regarded as a secondary issue, it was accepted as inevitable by-product of rapid growth strategy, as so vigorously pursued by the Korean government. This article is organized as follows. Section I presents the brief history of price changes in the process of Korean economic development since 1962. Section II examines the main issues with respect to inflation in Korea. A brief conclusion follows in section III.
I.
THE RECORDS
OF INFLATION’
The period from 1962 to the present is divided into five subperiods, reflecting the trend and feature of price movements. 1. 2.
1962-1964: 1965-1969:
3. 4. 5.
1970-198 1: 1982-1987: 198% :
high inflation relatively low inflation: formation of an inflationary core in the economic structure high inflation: deepening of inflation low inflation: stabilization of price level recurrence of inflation
Inflation at the Outset of Development Planning (19621964) Beginning in 1962, the government launched a series of five-year economic plans. Due to rapid growth-oriented strategy, the annual average GNP growth rate in this period was 8.3 percent, which was above the target rate. High rate of GNP growth, however, coincided with a high rate of inflation. For example, the wholesale price index (WPI) rose at an annual average rate of 27.5 percent in 1963 and 1964. Reasons of this high inflation rate can be explained as follows: First, the ratio of fiscal investment and loans was high (see Table l), which led to excessive liquidity. Second, as the supply capacity of the real sector was inadequate to absorb the growth in demand, the shortage of goods and inflation followed. Especially, the low productivity of agriculture induced an increase in agricultural product prices. Third, the 1964 devaluation of the Korean won, in the face of deficit in balance of payments after 1962, increased the prices of imported goods.’ In this respect, this period may be termed as the era of growth-derived inflation. An inflationary core caused by the rapid growth-oriented and unbalanced development strategy began to be manifest.
Economic Development and lnjlation
315
TABLE 1. Trends of Fiscal Investment and Loans in the 1960s (Unit: billion won) Year
Fiscal Investment and Loans (A)
Domestic Credit (B)
A/B
27.2 27.3 23.6 29.5 62.5 79.0
54.8 65.6 71.4 100.0 130.5 231.5 429.7 684.0 866.6
0.49 0.41 0.33 0.30 0.47 0.34 0.27 0.25 0.21
1962 1963 1964 1965 1966 1967 1968 1969 1970 Source:
117.6 175.5 184.3 KDI,
Four decades of Public
Finance
in Korea; The Bank of Korea,
Economic
Statistics
Yearbook.
Formation
of an Inflationary
Core in the Economic Structure (1965-1969)
During 19651969, prices were stable in comparison with those in the earlier stage of development. Consumer Price Index (CPI) and Wholesale Price Index (WPI) increased at an annual rate of 11.4 percent and 7.5 percent, respectively, between 1965-1969. These rates were fairly low compared to those of other periods, albeit they were higher than those in other advanced countries. Such relatively stable price level can be explained by several specific factors: (1) mitigation of excess demand by the development of manufacturing, (2) increase of imports, and (3) less foreign disturbances due to stable exchange rate and low international raw material prices. Although prices increased at a lower rate in this period, the price level maintained an upward movement. As rapid growth-oriented strategy continued, high growth rates of money and investment fueled the inflationary pressure. Internally, the relative price relations between agricultural and manufactured products changed, whereas the Korean price structure in general remained vulnerable to foreign factors. Moreover, Korea’s new industrial structure with domination of large oligopolistic firms much dependent on external factors, encouraged formation of a cost-push inflation core. Therefore, this period can be considered as one when the germination of an inflationary economic structure in Korea took place. Deepening of Inflation (1970-1981) It was in the 1970s that the Korean economy entered the stage of full-scale economic growth. At the same time, however, the Korean economy experienced a high rate of inflation. The WPI and CPI surged by 18.5 percent and 16.7 percent, respectively, on an annual average during 1970-1981. Inflation in the 1970s was characterized by cost-push factors, in contrast to 196Os, when inflation in Korea was mainly caused by demand-pull factors. Cost-push factors,
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84
86
86
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88
89
90
(4)2,1993
91
Figure 1. Wholesale Prices Changes. (Rates of Changes from the Previous Year.)
such as the two oil shocks and other crucial domestic supply bottlenecks primarily contributed to inflation in this decade. A recession, in the beginning of the 1970s made firms more vulnerable to the cost-push factors that had remained latent until then. These factors were excessive investment in equipment, inefficient business management, high financial costs3 incurred by excessive borrowing in the credit market, and an increase in prices of imported raw materials due to the devaluation of the Korean won as a policy measure to cut down deficits in the balance of payments.
TABLE 2.
Balance of payments and Exchange Rate (Unit: millions US $. won/US $)
Year
Current Balance
Trade Balance
Exchange Rate’
1970 1971 1972 1973 1974 1975 1976 1977 1978 1979 1980
-622.5 -845.7 -371.2 -308.8 -2.022.7 -1J386.9 -313.6 12.3 -1,085.2 4.151.1 -5.320.7
-922.0 -1.045.9 -573.9 -566.0 -1,936.8 -1,671.4 -590.5 476.6 -1,780.8 -4,395.5 -4.384.1
316.70 373.20 398.90 397.50 484.00 484.00 484.00 484.00 484.00 484.00 659.90
Note:
Source:
‘Exchange rate is the Bank of Korea concentration base rate at the end of year. The Bank of Korea. Economic Statistics Yearbook.
Economic Development and inflation
TABLE 3.
Comparison
317
of Prices of Agricultural
and Non-Agricultural
Products
(Unit: %)
Agricultural Non-agricultural Source:
1972
1973
1974
197.5
1976
9.1 8.3
9.0 16.6
41.9 44.0
28.0 18.1
19.2 6.3
Economic Planning Board, Price Level and Living conditions, 1982
Especially, a sharp increase in prices of international raw materials including crude oil led to the general price surge in the 1970s. Figure 1 clearly shows that the prices of raw materials increased a lot faster than those of capital goods, or of consumer goods. However, if it had not been for the strategy of export-driven industrialization and rapid growth adopted by the Korean government, the influence of the oil shocks on the general price level could have been much smaller. The oil shocks had much more impact, because it brought about a bigger deficit in the balance of payments which prompted major devaluations of the won twice, first in 1974 and again in 1980 (see Table 2). These devaluations pushed up import prices and then general prices. The prices of agricultural and marine products also had shown a steep upward trend from the beginning of this period. At the turn of the decade of the 1960s the share of manufactured products in GNP became larger and agricultural output fell short of the demand due to increases in income and urbanization. This explains why the increase of agricultural price led to general price increase during this period (see Table 3). Stabilization
of Inflation
(19821987)
The price level in Korea became exceptionally stable from 1982 to 1987. During this period, the annual average increase of WPI and CPI rates were only 0.2 percent and 2.8 percent, respectively. Some argue that this stabilization could be mainly due to anti-inflationary policies, such as, tightened money supply and direct price control. However, these policies did not seem to be a major cause of stabilization, since the inflation rate of Korea was not any lower than that of other countries (see Table 4). Stabilization of international raw material prices, rather than the government’s anti-inflationary policy, was the principal contributory factor. This stabilized the prices of manufactured products, and then the general price level. The price stabilization in this period underscored the fact that the Korean economy had a high degree of dependency on foreign factors, truly exogenous to Korea and beyond the control of the Korean government. Another noticeable change could be found in the relative price between light and heavy industrial products. During 1971-1979, excepting 1974 and 1975 when impact of the first oil shock was severe, price increased at an annual rate of 2.3 percent for light industrial products and 4.9 percent for heavy industrial products. During 1982-
JOURNAL OF ASIAN ECONOMICS, (4)2,1993
318
TABLE 4.
International Comparison of Inflation Rates (19821987 on average) (Unit: %)
WPI CPI Note: Source:
Korea
U.S.
Japan
Taiwan
0.2 2.8
0.6 3.3
-3.3 1.4
-2.0 0.5
Singapore -3.1 0.7
‘The baseyear is 1985 (i.e., 1985 = 100). except for Taiwan (i.e., 1986 = 100) National Statistical Oftice., Major Economic Indicators Abroad.
1987, the pattern of price variation changed as the two prices increased at an annual rate of 1.2 percent and -0.8 percent, respectively. As cost-push factors came to be controlled, the price of noncompetitive goods became also stable. While the inflation rate of competitive goods was 1.1 percent, that of non-competitive ones was -0.8 percent. This was because the heavy industry sector with high capital intensity and high dependency on international raw material market enjoyed the non-competitive market conditions. Therefore, the drop of foreign costpush factors explains much of the stabilization of inflation during these six years. Recurrence
of Inflation
(198% )
From 1988, prices again started to rise very sharply. The CPI increased at the rate of 8.6 percent and 9.3 percent in 1990 and 1991, respectively. The recent inflation shows different features from the previous ones. First, the gap between WPI and CPI has widened. Both of these indices had previously moved in the same direction, although there had been a difference in their rates of increase. But recently the difference between CPI and WPI widened by a rapid rise in the CPI in comparison with the relatively stable WPI. Second, the service sector prices have risen higher than the prices of manufactured products.4 Also the relative prices within the manufactured products changed remarkably. The inflation in this period was mainly led by the price increases of manufactured products from relatively light, labor-intensive consumer goods industries, whereas the previous inflation was led by those of manufactured products of heavy industries, which were more capital-intensive, and which used more of intermediate goods.’ It is especially remarkable that the recent inflation has been unaffected by foreign factors. Inflation is mainly due to the increase in money supply and the speculative flow of funds caused by the influx of foreign exchange holdings, the rise of wages and service prices, and the increase in construction investment. The expansion of the domestic market and the changes in consumption expenditure explain recent inflation. The share of expenditure on durable goods in household consumption has increased sharply from 3 percent at the end of 1970s to 9.6 percent in 1990 (see Table 5). The change in the pattern of consumption also led to the price rise following increases in aggregate effective demand.
Economic Development and inflation
TABLE 5.
Composition
319
of Household Consumption
Expenditure
(Unit: o/o,constant price) 1986 1987 1988 1989 1990 Source:
Durable goods
Semi-durable goods
Non-durable goods
Services
6.8 8.2 8.8 9.1 9.6
9.1 9.6 9.7 9.6 9.5
47.8 46.9 46.1 45.6 45.0
35.1 35.3 35.4 35.1 35.9
The Bank of Korea, National Accounts.
Therefore, the wage rises and the changes in consumption pattern accompanied by income increases due to rapid economic growth are the important contributing factors to the recent inflation, generally reflecting changes in the demand structure. But we note that the cost-push inflation structure still exists, because the price stability of non-competitive and heavy industrial products is mainly due to the stability of the prices of international raw materials.
II.
MAIN ISSUES WITH RESPECT TO INFLATION
In this section we discuss several major issues connected with inflation. First, the relationships between inflation and money supply as well as cost-push factors are examined. Second, we examine whether inflation is inevitable to rapid economic growth. Third, the relationship between inflation and income distribution is investigated. Money Supply and Inflation Many studies (Hong 1990; Park 1982) on the relationship between money supply and inflation report empirical findings on a positive correlation between the two aggregates. Economists, however, disagree as to whether money supply is the most important determinant of inflation. The strict monetarist view that monetary expansion is necessarily the main cause of inflation is not verified in Korea. Looking at the movements of inflation rate and money growth rate during 1971-1991 (see Figure 2), we observe no close relation, even if lagged effects are taken into consideration. The reason for the scant support for the monetarist view is attributable to peculiar characteristics of the Korean economy. First, the extent of monetization has deepened, as the economy has been growing. As a result of monetization, income velocity of money has decreased since 1975 (see Figure 3). Second, and more importantly, there exist price rigidities in the Korean economy. The government has pursued a direct price control policy. It preferred a direct control of prices at the micro level, rather than an adjustment of macro variables via policies
JOURNAL OF ASIAN ECONOMICS, (4)2,1993 “V
._
-1 m 71
72 73
74
75
76
Figure 2.
77
78
79
80
81
82
83
64
85
66
87
88
89
90
91
Money Supply (M2) and Wholesale Price Changes. (Rates of Changes from the Previous Year.)
of demand management. In other words, demand changes initiated from the increase in money supply could not affect prices, because government directly controlled the price of major individual items including public utilities and necessities. Especially in the 197Os, the prices of major manufactured products and necessities were under the control of the government. Accordingly, price changes were sharply enforced by so-called “price realization” at a given time. Thus, prices moved in an irregular pattern rather than monotonously and smoothly. Another factor attributable to the price rigidity was the oligopolistic nature of the Korean industrial structure. By monopolistic pricing, some big firms tended to stick to the previous prices, even when cost decreased. GNP/M2
26
$0
71
72
73
74
75
76
77
Figure 3.
78
79
fX
81
62
83
84
Income Velocity of Money
85
86
87
88
89
w
321
Economic Development and lnflation
Third, the main objective of monetary policy was not price stabilization. In the 1970.3, monetary policy focused on the efficient allocation of the limited funds to promote some selected industrial sectors. Monetary control was carried out in a limited scope to absorb the excessive liquidity by credit increases. Thus, the target variable of monetary policy was the level of domestic credit in the 1970s because government wanted to effectively supply funds to the domestic sector to finance the enormous investment demand with limited exposure to international risks. Furthermore, it did not need to worry about the growth of Ml or M2, as long as the monetary target was domestic credit, enabling it to guarantee a constant amount of credit to domestic firms. This implies that price stability was not the main objective of the Korean monetary policy. Despite all these arguments against the monetarist view, money should be regarded as one of the important factors of inflation on the demand side. However, even in the 1970s and in the early 198Os, when the monetarist view was supported by the basic guideline of monetary policy, economic circumstances induced the monetary authorities to change the target rate of money growth quite frequently. Moreover, actual growth rates also deviated significantly from the target rates (see Table 6).
TABLE 6.
Target and Actual Rates of Main Monetary Aggregates (Unit: %)
Monetary Aggregate
Target Increase Rate
Actual Rate
Domestic Credit (MI) 1970 27.0 1971 PI 28.0 1972 * 24.0’ 1973 w 24.0 + 28.0 1974 v 33.7 1975 w 35.3 1976 w 26.1 + 23.8 (20 + 28) 1977 H 24.1 -24.7 (23-25) 1978 w 34.2 (30.3) Domestic Credit Mz(M1) 1979 25.0 (23.6) 1980 v 20.0 + 25.0(15+20) 1981 0 25.0(23.0) 1982 w 20-22 + 25( 18-20) 1983 ?P 18-20-+ 15 1984 w 11-13 1985 m 9.5 1986 m 12-14 + 16-18 1987 * 15-18 1988 0 15-18 Note:
‘Target
24.6 26.9 25.0 27.0 15.2 7.7 15.6 18.4 19.1 21.5
(20.7) (16.3) (4.6) (45.6)
Rate at the end of June
2Values in parenthesis indicate auxiliary Source:
28.0 31.1 30.4 31.7 54.2 32.2 21.7 (30.7) 23.6 (40.7) 45.9 (34.9)
target values
The Bank of Korea, Annual Report and Economic
Statistical
Year Book.
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In sum, it can be asserted that money supply did not directly affect the inflation in Korea, but had only an indirect effect on inflation by way of increasing demand pressure, such as government investment, domestic credit for firms, and foreign currency loans. 2.
Cost-Push Factors and Inflation
The past two decades in Korea witnessed cost increases as a major determinant of its high rate of inflation (Park 1992). The cost-push was originated from high corporate financial costs and the devaluation of the currency in the 1970s price increases of imported raw materials including crude oil, first in 1974 and again in 1980, and increases in wages since 1988. The distinctive feature of cost-push inflation in Korea is clearly shown when the WPI increase rates in Korea during the two oil shocks are compared with those in other countries (see Table 7). It tells us that the price in Korea responded more sensitively to the cost increase than that in other countries, as indicated by a rapid rise in WPI. Then, the question arises what was the structural feature to shift cost-push toward inflation in Korea. In the first place, it is Korea’s relatively high degree of dependency on the foreign factors. It contributed to the evolution of an inflationary core in the Korean economic structure in two aspects. One aspect is that domestic prices have been immediately influenced by foreign price changes due to Korea’s deep import-dependency. The average degree of import-dependency marked 12.9 percent across all industries in 1985, especially 21.7 percent in the case of manufacturing and 28.2 percent in heavy industry (see Table 8). Export-driven industrialization, which prompted the importation of raw materials and intermediate goods for exporting manufactured goods, rendered the industrial structure very much dependent on the foreign factors (see Table 9). At the same time, the import increase resulted in the external deficit and the decrease of foreign currency holdings. To correct this problem, the government adopted currency devaluation and import restrictions, which further acted to boost inflation.6 In this sense, export-driven growth could be achieved only along with the sacrifice of price stability. The co-movement between WPI and import price index over the past two decades mirrors this fact as Figure 4 indicates.
TABLE
7.
Increase
Rates of WPI During
Oil Shocks
(Unit: o/o) 1974 1980 Source:
Korea
U.S.
Japan
420 39.0
18.8
32.1 14.9
18.3
National Statistical Offices. Major Economic Indicators Abroad.
W. Germany 13.6 7.5
Taiwan 40.8 21.6
Singapore 20.0
Economic Dmelopment and Inflation
323
TABLE 8.
Import-Dependency
by Industry (Unit: %o)
1975 Agriculture, Forestry & Fishing Mining Manufacturing Light Industry Heavy Industry Services All Industries Now
Import-dependency
1980
2.4 4.0 21.9 13.6 33.8 3.3 12.8
1985
2.2 0.6 22.7 13.7 31.1 7.0 14.2
= (Input of intermediates importedfMa1
1.8 0.7 21.7 13.2 28.2 4.7 12.9
output) x 100
Source: The Bank of Korea, 1985 Input-Output Tables.
TABLE 9.
Composition
of Imported Goods (Unit: 700)
Intermediate Goods
Capital Goods
Consumption Goods
74.3 82.1 84.5
20.2 13.9 11.6
5.5 4.0 3.9
1975 1980 1985 Source:
’
-10’ 71
72
The Bank of Korea.1985
’
’
’
’
’
Input-OutputTables.
’
’
’
73 74 75 76 77 78 79 80
-
WPI
+
’
’
’
’
’
’
’
’
’
!
81 82 83 84 05 86 87 80 89 90 Import
prices
Figure 4. Wholesale Prices and Import Price Changes (Rate of Changes from the Previous Year)
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Figure 5.
78
79
80
Competitive
81
82
83
OF ASIAN ECONOMICS,
04
06
*.,..... Noncompetitive
86
07
80
89
90
(4)2,1993
91
1
Competitive and Non-competitive Commodity (Rate of Changes from the Previous Year)
Prices.
Second, the establishment of oligopolistic industrial structure and the unbalanced growth in industry further contributed to cost-push inflation. The industrializationoriented development strategy not only caused severe imbalance between agriculture and manufacturing, 7 but also changed the structure of relative prices between the agricultural and non-agricultural products.* As manufacturing became priority and thus relatively more important, changes in the price of manufactured products dominated movements in general prices.’ After the mid- 197Os, the prices of heavy and chemical industrial products have led general prices, and this has mainly been due to the price setting by a few big firms with oligopolistic power. The mark-up pricing policy of big firms has significantly contributed to price rises, because the price had downward-rigidity. Cost increases raised not only their own prices but also the prices of other products sequentially. Some evidence for the two reasons mentioned above is as follows: First, the ratio of sales costs to total sales exhibits more stability in big firms than in small and medium firms.” It might show that the mark-up ratio in the big firms stayed at a constant level. Second, considering the different pricing rule between the competitive and noncompetitive commodities, as is illustrated in Figure 5, we see that the price increase in a noncompetitive commodity was higher than that in a competitive commodity in 1972, 1974-1975 and 1980, when the international price of raw materials and the corporate financial costs rose. In addition to firms’ behavior, the government’s price policy contributed to uphold mark-up pricing. In 1975, the government adopted “Fair Trade Act” under which some producers were permitted to raise their prices following the rate of increase, as
Economic Development and Inflation
325
determined by the government. Under this scheme, the government approved the rate of increase for the pre-determined items by just adding some fixed mark-up ratio to cost data offered by the firms. This kind of direct price control made it possible for the firms to transfer cost increases to the consumers. This became very evident whenever firms were in serious trouble throughout the 197Os, during which the Korean economy experienced the two oil shocks.” 3.
Inevitability of Growth-Derived
Inflation
Some economists take the view that inflation is an inevitable consequence of economic growth, especially when the rate of growth is so rapid. That is, inflation in Korea has been a necessary evil to achieve rapid economic growth. Generally in underdeveloped countries, economic growth accompanies increases in investment demand to enhance production capacity which is financed through expansionary fiscal and monetary policies, as well as in consumption demand which is a result of growth in employment. However, as productivity of industry lags behind growth in demand, it spurts inflationary pressure. It follows that underdeveloped countries have to endure inflation, unless they abandon the goal of rapid growth. However, it is doubtful that inflation is indispensable in the process of rapid growth. On the contrary, inflation can impede economic growth.12 As a matter of fact, there were several sub-periods when economic growth and inflation did not go together (see Figure 6). Apart from the period of the oil shocks which showed severe stagflation, there were also periods when recession went handin-hand with inflation. It is to be noted that the price-level remained stable during some period of rapid growth, as in 1986 and 1987.13
-
GNP
growth
rate
+
CPI increase
rate
Figure 6. Economic Growth and Price Changes. (Rates of Changes from the Previous Year.)
326
JOURNAL OF ASIAN ECONOMICS,
.a.’ . . .....
.
.... .. ..
. . . . . . . .q,
3’ ‘*., ‘Q,
I.,,
a..,
:
j
3:s
(Unemployment
Figure 7.
I
1
.~~~..~__..._..__....~............ .::
-90 ‘-+3 eq. .a
2:5
jz6j ._......,,..,. i __,. fri ‘1 ;: ! ; j.h72
(4)2,1993
i
415
rate, %)
5.6
Phillips Curve (1971-1990)
We may look at the relationship between the two from the point of view of the Phillips curve. But when we draw the Phillips curve of the Korean economy, it is hard to observe that the curve moves downward to the right (see Figure 7).14 The assertion that inflation is inevitable as a result of rapid growth can be refuted by comparing the inflation rate of Korea with that of Taiwan which recorded a comparable high rate of growth. During 1971-1990, the price-level of Taiwan was relatively stable, with an annual average increase rate of 6.9 percent for CPI and that of 4.8 percent for WPI, in contrast to the Korean rates of 11 .Opercent and 10.5 percent, respectively. Moreover, after 1974, the annual average growth rate of money (M2, period-end basis) in Taiwan was 22.2 percent, whereas that of Korea was 23.1 percent. It is remarkable that the gap of inflation rates between two countries was so visible, despite the small difference in their money supply growth rates. This implies that inflation in any one country does not simply depend upon the economic growth and money supply, but is strongly influenced by the industrial structure and economic development strategy.r5 The Korean government’s policy accelerated inflation under rapid economic growth. Throughout the period in the 1960s and 1970s government did not actively exercise the restraint over aggregate demand to curb inflation. The basic attitude of the government was, to a certain degree, to accept inflation, while alleviating its adverse side-effects. The government adopted a micro-level price policy, such as, price controls over specific goods or products of a specific sector, rather than a macro-level price policy for restraining aggregate demand, because government would not abandon the rapid growth strategy (see Table 10). Even in the 1980s rapid growth, not price stability, received higher priority in the Korean government’s policy. During the period of stagflation in the early 198Os, the government emphasized a policy of increasing exports to contain the situation. When
Economic Development and Inflation
TABLE 10. Time 1976.3 1977.5 1978.7 1979.2 1979.4 1979.12 1980.12 1981 1982 Source:
327
Trends in Government
Numbers of Items
Number of Firms
148 157 148 74 46 35 35 97 67
247 272 257 124 81 58 58 152 87
Time 1983 1984 1985 1986 1987 1988 1989 1990
Price Control Number of Items
Number of Firms
58 52 47 43 42 38 36 33
74 73 64 61 59 51 47 45
Economic Planning Board, Economic White Paper
the firms were in difficulties and the economy was in recession, the government took action to “realize” the prices of commodities, which enabled the firms to shift the increased costs to commodity prices. Indeed, direct control over price was the major device of the government’s price policy. It follows that inflation-control has been secondary in policy agenda. The government in implementing its economic growth policy has tacitly accepted the inflation. 4.
Inflation
and Income
Distribution
Inflation, which caused a discrepancy between nominal and real values, provided firms with favorable conditions for rapid growth by lessening its real financial cost and real wage cost. First, inflation alleviated the financial cost for firms which are mostly dependent on loans from the financial institutions by reducing the real interest rates. Table 11 presents real interest rates, and demonstrates that interest rates were kept low over the whole period. l6 For some years when real interest rates were negative, firms increased their real incomes by getting loans from the financial institutions. In particular, considering the fact that the interest rates on preferential loans were kept lower than those on general loans, and that the proportion of the preferential loan was very high,17 we easily recognize that low interest rates greatly reduced the financial costs of firms. Low interest rate was, however, a barrier in increasing domestic savings. Since the domestic investment ratio was higher than the domestic saving ratio, the monetary authorities increased money supply by borrowing from the Bank of Korea, which resulted in the inflationary pressure. Under this financial structure, the accelerated inflation rates stimulated firms to shift their financial costs to others.18 Second, inflation also provided firms with favorable conditions for overcoming the recessions as production costs were reduced by lowering the real wage rate. With regard to the relationship between wages and prices, the main point of discussion is the causality between the two variables. The wage-control policy during the early
328
JOURNAL
TABLE 11.
OF ASIAN ECONOMICS,
(4)2,1993
Real Interest Rates, Increase Rate of Real Wage, and Real Estate Prices (Unit: %) Real interest rate
1971 1972 1973 1974 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 Note:
Curb market Increase rate of Increase rate of Increase rate of real interest rate real wage house price land price
8.0 3.8 12.3 -8.8
36.4 27.3 30.3 16.3
8.6 4.2 8.1 11.0
36.7 14.6 14.9 17.6
-
-9.9 2.7 6.0 4.5 0.8 -8.7 -5.6 2.9 6.6 7.7-9.2 7.5-9.0 7.2-8.7 7.0-8.5 2.9-5.9 4.3-6.8 1.4-3.9
26.0 25.2 28.1 26.7 24.2 16.2 13.7 23.5 22.4 22.5 21.5 20.8 20.0 15.6 13.4 10.1
1.6 19.4 24.7 19.0 10.4 -6.0 -1.5 7.6 8.8 5.8 7.4 6.4 8.6 12.6 19.4 11.6
38.6 27.3 24.6 30.8 37.8 26.8 21.2 2.3 22.6 3.1 0.0 -3.0 5.3 15.6 17.5 16.7
27.0 26.6 33.5 49.0 16.6 11.1 7.5 5.3 18.5 13.2 7.0 7.3 11.2 27.2 32.8 20.0
‘real interest rate = interest rate on other bills - CPI growth rate *increase rate of real wage = increase rate of monthly ‘Curb
Source:
average nominal wage in manufacturing
- CPI growth rate
market real interest rate = curb market interest rate - CPI growth rate
Economic
Statistics Yearbook,
Statistical
Offices:
The Bank of Korea: Annual Report on the Family
Trends in Land Prices, Ministry
Income and Expenditure
Survey. National
of Contraction.
1980s could be justified by the argument that wages are one of the most important factors of inflation. But it has not been empirically demonstrated yet.” Due to inflation, firms could enjoy rapid growth by reducing production costs through the reduction of wage costs and financial costs, and also by shifting them to other sectors. In other words, inflation worsened income distribution by redistributing income in favor of firms.*’ Indeed, inflation had more influence on income distribution than what the estimated values may suggest. Because inflation were more beneficial to real asset holders, the accelerated inflation led to speculation in real assets as a good hedge against inflation. The two most popular assets for speculation in Korea are land and houses. Soaring real estate prices reflect heavy speculation in these assets (see Table 1 I), which widens the wealth inequality between asset holders and others. Furthermore, if we take into consideration the fact that the price of lands and houses is hardly included in
329
Economic Development and Inflation
calculating the price index, the real effects of inflation on income distribution be much greater than otherwise reported. III.
would
CONCLUSION
Inflation has been closely associated with the economic development strategy in Korea. This strategy is characterized by rapid growth-orientation-fast industrialization, export-driven, and big firms-centered industrial structure. The resultant industrial structure, a highly monopolistic and oligopolistic structure, is highly dependent on foreign factors, and has caused a serious decline of the agricultural sector. The external dependency of industrial structure generated a price structure in which domestic prices have remained highly sensitive to foreign price movements. In addition, the balance of payment deficits had induced the government to adopt currency devaluations and import restrictions, which further spurted inflation. The monopolistic and oligopolistic industrial structure gave rise to a price structure where cost increases are easily linked to price increases, resulting in consequential price increases of all other products. The slowdown of agriculture had been another factor adding to the inflationary pressure. Inflation in Korea is essentially cost-push and it originated from its economic growth strategy. Therefore, it cannot be justified that the inflation must be tolerated for rapid economic growth. In fact, the government gave top priority to rapid growth and took price stability as the secondary policy target. Inflation in Korea, however, did not originate from economic growth itself. So it is unacceptable that inflation must be tolerated for rapid growth. This can be supported by the fact that in Korea the correlation between GNP growth rate and inflation rate is not observed. Inflation in Korea worsened the income distribution by redistributing incomes in favor of large firms and stimulating speculations in land, house, and so on. In particular, the expansion of speculations due to inflation aggravated the inequality in income distribution. NOTES 1. For the values which are not specifically mentioned, see appendix tables, available on request from the author. 2. Government exercised devaluation from 130 won to 256 won per U.S. dollar in May 1964. 3. The adjustment of official interest rates to the market rates in 1965 contributed to lowering inflation rate and promoting savings. This measure, however, became responsible for not only the unhealthiness of financial institutions by the provision of negative spread of frequency, but the increase of corporate financial cost. 4. Service prices and the prices of manufactured products increased at the annual average rate of 8.3 percent and 4.6 percent, respectively, during the period of 1988-1991: 5. The annual price increase rates by sector during 1988-1991 is as follows. 1. light industrial products: 2.9 percent vs. heavy industrial products: 2.1 percent
JOURNAL
OF ASIAN ECONOMICS,
(4)2,1993
2. intermediate goods: 1.3 percent vs. consumption goods: 6.0 percent 3. labor-intensive products: 7.7 percent vs. capital-intensive products: 1.4 percent. 6. In the 197Os, under a direct exchange control regime, the government used devaluation as a policy tool for achieving export promotion and the improvements in the external deficits. Each devaluation in 1970, 1974 and 1980 produced a rapid rise in domestic prices during the respective period, see Table 3. 7. Note that while the average growth rate of agriculture and fishing was 2.23 percent during the period of 1965-1990, that of manufacturing was 15.58 percent during the same period. 8. The price indexes for agricultural and manufactured products were 9.0 and 16.5 at the end of April 1970, but they were 108.3 and 157.8, respectively, at the end of December 1991. 9. From 1970 to 1990,72 percent of the general price changes can be explained by changes in the price of manufactured products, while 20.3 percent in the price of agricultural products. 10. Notice that the variance of sales costs to total sales ratios in the big firms and the small and medium firms were 0.38 and 0.58 during the period of 1975-1990. 11. For example, government raised the prices of oil and other products about 30 percent in December 1974, and 3 1.3 percent in December 1975. 12. SeeMeier(l976,p. 321 &pp. 311-315). 13. The relation between GNP growth rate and price increase rate is very suggestive. Calculating the cross correlation coefficients between annual GNP growth rate and annual GNP deflator growth rate during the period of 1971-1991, the correlation between them does not exist at the significance level of 5 percent. When GNP deflator growth rate is replaced with CPI growth rate or WPI growth rate, the result is the same. causality test also suggests the same. Analyzing quarterly GNP and GNP deflator data, we cannot find the causality between economic growth rate and inflation rate. 14. There has been no clear conclusion on the debate over the downwardness of the Phillips curve. But a recent study claims to demonstrate that the long run Phillips curve does not have a downward slope. See Jun (1991). 15. According to one study, despite high monetary growth, Taiwan was able to maintain a lower rate of inflation, because the increase in demand for money in Taiwan resulted from the difference in industrial structure and increased desire of people to hold money as a instrument of savings. See Korea Economic Research Institute (1986). 16. Owing to the regulation, bank interest rate is very different from the market interest rate as is represented by the curb market interest rate, see Table 11. 17. The gap between interest rates on preferential loans and those of general loans widened as much as 18 percentage points, and the proportion of preferential loans among new loans extended generally remained at about 50 percent. 18. There is a counter argument that it is a high interest rate policy that causes inflation. According to Taylor, the increase in the interest rate is a source of inflation due to the fact that it reduces aggregate supply rather than aggregate demand in underdeveloped countries, and hence low interest rate policy is more appropriate for price stabilization in the case of underdeveloped countries. See Taylor (1991). 19. Most researchers conclude that there is a mutual causation between wages and prices. 20. Gini’s coefficients and multiples increased when prices rose high.
REFERENCES Hong, Kap-Soo.
1990. “On the Relations of Inflation to Wages, Money Supply and Growth in Korea.”
Monthly Bulletin (Bank of Korea),
Jun, Sung-In. Economic
44(5):
41-64.
1991. “Comparative Study on Models for Estimating Outlook, 10( 1): 95-l 18.
Nominal Wages,” KDI Quarterly
Economic Development and Inflation
331
Korea Economic Research Institute. 1986. Monetary Policies and Prices of Korea and Taiwan, Seoul. Meier, Gerald M. (ed.). 1976. Leading Issues in Economic Development, New York: Oxford University Press. Park, Kwang-Min. 1992. “Characteristics and Determinants of Recent Inflation in Korea.” Monthly Bulletin (Bank of Korea), 46( 10): 3-27. Taylor, Lance. 1991. Income Distribution, Inflation and Growth, Cambridge, Mass.: MIT Press.
Received November
1992; Revised May 1993