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The effects of government spending shocks on the trade account balance in Korea
Accepted Manuscript The effects of government spending shocks on the trade account balance in Korea Hyeongwoo Kim, Daeyup Lee
PII:
S1059-0560(17)30314-3
DOI:
10.1016/j.iref.2017.10.001
Reference:
REVECO 1504
To appear in:
International Review of Economics and Finance
Received Date: 18 April 2017 Revised Date:
27 September 2017
Accepted Date: 2 October 2017
Please cite this article as: Kim H. & Lee D., The effects of government spending shocks on the trade account balance in Korea, International Review of Economics and Finance (2017), doi: 10.1016/ j.iref.2017.10.001. This is a PDF file of an unedited manuscript that has been accepted for publication. As a service to our customers we are providing this early version of the manuscript. The manuscript will undergo copyediting, typesetting, and review of the resulting proof before it is published in its final form. Please note that during the production process errors may be discovered which could affect the content, and all legal disclaimers that apply to the journal pertain.
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∗ The views expressed herein are those of the authors and do not necessarily reflect the official views of the Bank of Korea. When reporting or citing this paper, the authors’ names should be explicitly stated. † Department of Economics, Auburn University, 217 Miller Hall, Auburn, AL 36849. Tel: (334) 844-2928. Fax: (334) 844-4615. Email: [email protected]. ‡ Economic Research Institute, Bank of Korea, Seoul, South Korea. Email: [email protected]
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October 6, 2017 Abstract
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Hyeongwoo Kim and Daeyup Lee
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The Effects of Government Spending Shocks on the Trade Account Balance in Korea
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This paper investigates fiscal policy effects on the trade account balance in Korea using open economy vector autoregressive (VAR) models. In response to fiscal spending shocks, real appreciations occur, followed by deteriorations in the trade account balance with the pre-2000 sample period, while real depreciations occur leading to an improvement in the trade account balance with the post-2000 sample period. We explain this structural break in relation to Korea’s transition from a tightly managed exchange rate regime to a more market-oriented floating system after Korea’s foreign exchange crisis in 1997-98. Furthermore, such fiscal policy effects from our post-2000 sub-sample imply that expansionary fiscal policy can be effective in stimulating private sector economy in Korea.
Introduction
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Keywords: Keywords: Fiscal Policy; Trade Account; Twin Deficit; Twin Divergence; Real Exchange Rate; VAR JEL Classification: E32; E62; F32; F41
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This paper empirically investigates the effects of fiscal expansions on the trade account balance in Korea using an open economy vector autoregressive (VAR) model. Specifically, we study how the trade account balance responds to government spending shocks through the propagation mechanisms of the shock to other key macroeconomic variables such as consumption and the real exchange rate in Korea. We often discuss fiscal policy effects on the current account balance and the trade account balance interchangeably, since dynamic responses of these two series to the fiscal shock are qualitatively similar. This is because their business cycle components, which are relevant to VAR analysis, tend to exhibit very high correlation, even when the raw data show sizable differences over time.1 Standard economic theories (e.g., Baxter, 1995; Kollman, 1998; Erceg, Guerrieri, and Gust, 2005) provide straightforward explanations for the so-called twin deficit hypothesis. When government spending increases with no matching increases in tax revenues (fiscal deficit), Ricardian consumers, rationally expecting a tax hike in the near future, reduce consumption (increase saving) and increase labor hours. As capital becomes more productive due to an increase in labor hours, investment rises which then offsets the increase in private saving. Therefore, the current account deteriorates (current account deficit), resulting in a twin deficit. On the other hand, most undergraduate level macroeconomics textbooks such as Mankiw (2014) provides an alternative but simpler explanation on the twin deficit hypothesis. As the government spending increases, national saving decreases, which results in an increase in the real interest rate. Higher real interest rate then attracts more capital toward the domestic capital market, resulting in a decrease in the net capital outflow. At the same time, the decrease in the net capital outflows
1 In the case of the US, the difference is very small, so the current account and the trade account are often used interchangeably.
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causes the real exchange rate to go up (real appreciation), which deteriorates the trade account balance. On the contrary, Kim and Roubini (2008) report a short-run improvement in the current account balance in response to the fiscal deficit shock using the current floating exchange rate regime data in the US. The real interest rate increases as the public saving decreases, which then lowers private investment. Private saving rises due to a decrease in consumption. Overall, the increase in private saving and the decrease in domestic investment jointly outweigh the decrease in public saving, leading to an improvement in the current account balance. They named this empirical finding the twin divergence hypothesis. Their model, however, does not explain why the real exchange rate depreciates, which is crucial to explain the improvement in the trade account balance, even though the real interest rate increases in their model in response to a positive fiscal shock. Jia and Kim (2016b) revisit this issue introducing the role of consumer sentiment. Their VAR model estimates imply that private spending declines as the fiscal shock generates consumer pessimism. That is, unexpected increases in the fiscal spending confirm incoming decreases in productivity in the near future (news effect). Anticipating recessions, private sector agents reduce both private consumption and investment. Unlike Kim and Roubini (2008), they report a decrease in the real interest rate, which then results in a real depreciation. The trade account balance improves accordingly. Therefore, their work confirms Kim and Roubini’s (2008) twin divergence hypothesis, though their model also explains why the real exchange rate depreciates leading to an improvement in the trade account balance as well. In addition to these studies, M¨ uller (2008), Corsetti and M¨ uller (2008), Ravn, Schmitt-Groh´ e, and Uribe (2007), Beetsma, Giuliodori, and Klaassen (2008), Kollman (2010), Enders, M¨ uller, and Scholl (2011), and Kim (2015) also investigated fiscal policy effects on the real exchange rate (terms of trade) and/or the trade account balance. In the present paper, we study the fiscal policy propagation mechanism from Korean experiences that adds new insights to the current literature. Among earlier related research work, Kim and Kim (2006) implemented the Granger Causality test for the government budget balance, the current account balance, and the exchange rate using Korean data. Unfortunately, their empirical findings are not very informative.2 We employ open economy VAR models for quarterly observations from 1980:I to 2015:I to investigate how fiscal shocks influence the trade account in Korea. We obtained strong evidence of a structural break in the dynamic relationship between the government spending and the trade account balance around the year 2000 when Korea completed economic overhauls since Korea’s foreign exchange crisis in the late 1990’s. The trade account balance deteriorates in response to the fiscal spending shock only when we employ the pre-2000 data. We obtained similar responses of the current account balance, which is consistent with the twin deficit hypothesis. With the post-2000 sample period, however, the trade account balance improves in response to the fiscal shock, which is similar to the US evidence reported by Kim and Roubini (2008). That is, in contrast to previous results, we observed real depreciations that improved the trade account balance. We noticed that Jeong, Kang, and Kim (2017) reported similar findings for Korea and Japan in their three-country study for China, Korea, and Japan. That is, they also reported a structural break in the response of the trade account balance to the government spending shock in Korea. However, they are primarily interested in comparing the fiscal policy effects/multipliers in the three countries.3 On the other hand, we focus on the fiscal policy effects on the trade (current) account balance in Korea using various models and specifications. Furthermore, we provide detailed explanations on what caused this structural break in sections 3.3 and 4.1. Korea has undergone a major overhaul since its financial crisis in 1997-98. In what follows, we clarify the role of more flexible prices in financial markets in understanding our findings about fiscal policy effect on the trade account in 2 They report that the fiscal balance fails to Granger cause the current account, whereas the current account Granger cause the fiscal budget. Since Granger Causality does not imply causal relationships, their findings provide not much useful information as to the validity of the twin deficit hypothesis in Korea. 3 In a similar study, Ilzetzki, Mendoza, and Vegh (2013) reported that the fiscal multiplier tends to be large in economies under the fixed exchange rate regime. For countries with flexible exchange rates, however, they reported a negative fiscal multipliers both in the short- and in the long-run, which is in sharp contrast with results of Jeong, Kang, and Kim (2017) who found substantial and significantly positive output effects of fiscal policy for Korea and Japan during flexible exchange rate regimes.
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The Empirical Model
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Korea, relating it to Korea’s transition to a market oriented exchange rate regime after the crisis. In response to fiscal policy shocks, substantial nominal depreciations occur dominating rising domestic inflation rate, resulting in real depreciations under the flexible exchange rate regime in the 2000’s but not in the pre-2000 sample period. We also implement an array of robustness check analysis which confirm our major findings from the baseline model. Also, using the post-2000 data, we provide some evidence of effective fiscal policy in stimulating private activity in Korea via responses of consumption, consumer sentiment, and government tax receipts. The rest of the paper is organized as follows. Section 2 describes the econometric model. Section 3 provides data descriptions and preliminary analysis, then we report our major empirical findings. Section 4 provides further discussions and robustness check analysis. Section 5 concludes.
We employ the following pth order vector autoregressive (VAR) model for open macroeconomy data in Korea. Abstracting from deterministic terms,
where xt =
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xt = Φ1 xt−1 + Φ2 xt−2 + · · · + Φp xt−p + Cut ,
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and C is a lower-triangular matrix and ut is a vector of mutually orthonormal structural shocks, 0 that is, Eut ut = I.4 Our key variable gt denotes a measure of the government spending (govt ) such as the government consumption. For our baseline model, zt is the following. zt =
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where yt is a private spending variable such as private consumption (cont ) or private investment (ivtt ). nxtt is the trade account balance as a share of the total GDP.5 nirt is the nominal interest rate and πt denotes the inflation rate. Lastly, rert denotes the real effective exchange rate. We demean and detrend xt prior to estimations. We are particularly interested in the j-period ahead orthogonalized impulse-response functions (OIRF) of zt to the government spending shock, defined as follows. IRF (j) = E (zt+j |ug,t = 1, Ωt−1 ) − E (zt+j |Ωt−1 ) ,
(3)
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where ug,t is the structural shock to gt in (1) and Ωt−1 is the adaptive information set at time t − 1.6 Note that gt is ordered first in xt , meaning that the fiscal policy variable is not influenced by other variables in zt within one quarter. This assumption is often employed in the current fiscal policy literature (e.g., Ramey, 2011), which seems to be an innocuous assumption, because implementation of discretionary fiscal policy normally requires congressional approval. It is well documented that econometric inferences based on recursively identified VAR models might not be robust to alternative VAR orderings. Our major findings, however, are not subject to this problem. As Christiano, Eichenbaum, and Evans (1999) show, all response functions to the fiscal spending shock are invariant because gt is ordered first. Put it differently, all response functions to the fiscal shock are numerically identical even when one randomly rearranges variables in zt .
4 We employed an intercept and linear time trend for our VAR estimations. Our estimates are qualitatively very similar when we add quadratic trend term to those deterministic terms. 5 We also employ the current account balance (curt ) instead of the nxtt , which yielded qualitatively similar results. 6 That is, the information set has the following property, Ωt−1 ⊇ Ωt−2 ⊇ Ωt−3 ⊇ · · ·.
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3 3.1
Empirical Results Data Description
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We obtained all data from the Bank of Korea unless stated otherwise. Observations are quarterly and span from 1980:I to 2015:I. nxtt is the trade account balance as a share of the total GDP (gdpt ), which is the exports (extt ) of goods and services minus the imports (imtt ) of goods and services. The current account balance (curt ) is also defined as a share of gdpt . All public and private spending variables, the government consumption (govt ), the private consumption (cont ), and the total investment (ivtt ), are divided by the GDP deflator, then logtransformed. The BIS real effective exchange rate (rert ) is obtained from the FRED and logtransformed. The nominal interest rate (nirt ) is the money market interest rate, obtained from the IFS CD-ROM. We obtained the core Consumer Price Index (CPI) inflation rate from the same source. Our baseline VAR models utilize govt to identify the fiscal spending shock. In the current literature, however, researchers have employed alternative measures of the fiscal spending variables such as the government budget balance (or deficit) or the government net tax to control for the tax effect. Unfortunately, the real net tax (taxt ) data is available only for the sample period that begins in 2000:I. In what follows, however, we show that empirical evidence from an extended VAR model with taxt provides qualitatively similar results. And Kim (2015) discussed the benefits of using the government consumption shock in the current literature of the twin deficit/divergence. Therefore, our identification strategy with the government consumption seems to the best option available for a Korean case study, even though it is not an ideal choice.
Preliminary Analysis
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Figure 1 reports the Hodrick-Prescott (HP) cyclical (business cycle) components of our key variables: government consumption (govt ), total GDP (gdpt ), the current account balance (share of GDP; curt ), the trade account balance (share of GDP; nxtt ), and the real effective exchange rate (rert ).7 We also report correlations of these variables in Table 1. Some of notable findings are as follows. First, we find empirical evidence of counter-cyclical fiscal policy in Korea only for the post-2000 sample period (2000:I-2015:I). When the economy enters a period of recession, government may implement expansionary fiscal policy that may come in the form of increased government spending. As the economy improves, the government may switch to contractionary policy to reduce its fiscal deficit and possibly to dampen inflationary pressure. In the pre-2000 era (1980:1-1999:IV), however, the correlation between govt and gdpt was negligibly small (−0.045), whereas it has increased to −0.131 in absolute value during the post-2000 era. That is, we find an substantial role of output stabilization in the conduct of fiscal policy in Korea only from observations since 2000.
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Second, as we can clearly see in Figure 1, curt and nxtt exhibit very strong co-movement. The correlations were consistently high, 0.777, 0.811, and 0.696 in the full, the pre-2000, and the post2000 sample periods, respectively.8 On the other hand, nxtt (or curt ) and rert move in opposite directions, which is not surprising. Correlations were −0.602, −0.629, and −0.551 in the full, the pre-2000, and the post-2000 sample periods, respectively. In response to a sharp real depreciation triggered by Korea’s foreign exchange crisis in 1997, nxtt and curt both exhibit an abrupt and rapid hike. Similar dramatic changes are observed in around 2008 when the US Financial Crisis began, triggered by the collapse of Lehman Brothers in September 2008. We also note that nxtt exhibit counter-cyclical movements. That is, it seems that the trade account balance tends to improve in Korea during recessions. This is not necessarily an improvement, however, because Korean imports tend to fall more than exports during global recessions. Most importantly, we obtained negative correlation between govt and nxtt (or curt ) only from the pre-2000 era, while very small positive correlation was observed when we use the post-2000 observations. As we discussed before, Baxter (1995), Kollman (1998), and Erceg, Guerrieri, and 7 We set the smoothing parameter at 1,600 following the suggestion for quarterly data by Hodrick and Prescott (1997). 8 The difference between the current account and the trade account balance is the net amount received for domestically-owned factors of production used abroad.
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Figure 1 around here
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Gust (2005) among others predicted a deterioration of the current/trade account balance when there is a fiscal expansion shock (twin deficit ), whereas Kim and Roubini (2008) proposed an alternative hypothesis of the twin divergence based on their empirical findings for the post-war US data.9 That is, we observe evidence in favor of the twin deficit hypothesis from the pre-2000 sample period, while the data supports the twin divergence hypothesis for the latter sample period.
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To put in a nutshell, we obtained strong empirical evidence of a negative (static) relationship between the government spending and the trade account balance only for the earlier sample period. We also noticed a similar structural break between the government spending and the real exchange rate. In what follows, we investigate the dynamic effects of the fiscal expansion shock to the trade (and current) account balance in Korea using an array of open economy VAR models that are robust to alternative orderings.
Government Spending Shocks and the Trade Account
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We report dynamic responses of the trade account balance to the government spending (gt = govt ) shock via the orthogonalized impulse-response function (OIRF) estimate for the VAR model (1) and (2). We employed an intercept and linear time trend for estimations.10 Our benchmark model employs the private consumption (cont ) for the private spending yt . Using the total investment (invt ) instead produces qualitatively similar results.11 We also estimated the VAR model that replaces the trade account balance (nxtt ) with the current account balance (curt ), which again provided qualitatively similar results.12 All OIRF estimates are accompanied by one standard error confidence bands that are obtained by 500 nonparametric bootstrap simulations. Figure 2 provides strong empirical evidence of a negative dynamic relationship between the govt and nxtt from the full sample period. Since the impact, the trade account balance (nxtt ) starts to deteriorate persistently and significantly in response to the fiscal expansion shock. Initial adjustments are somewhat sluggish and the maximum response occurs in about 1.5 years. We also obtained quite similar dynamics for curt , which is consistent with the the twin deficit hypothesis. The real exchange rate exhibits persistent increases (real appreciations), which explains the negative responses of the trade account balance. The responses are overall statistically insignificant. It turns out, however, that this is due to pooling the two sub-sample periods together that generate qualitatively different responses of the real exchange rate to the fiscal shock.
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Figure 2 around here
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In Figures 3 and 4, we report OIRF estimates to the fiscal spending shock from the two subsample periods in order to investigate dynamic evidence of a structural break between govt and nxtt . When we employ the pre-2000 sample period, see Figure 3, the trade account balance decreases persistently and significantly in response to the fiscal spending shock, reaching the maximum response in around 1 year. Also, the fiscal spending shock yields real appreciations of Korean won, which explains the deterioration of the trade account balance. Both the nominal interest rate (nirt ) and inflation (πt ) rise when the fiscal shock occurs. It should be noted that private consumption (cont ) shows persistent increases that are highly significant, which is at odds with Ricardian consumers’ behavior. That is, consumers in Korea decrease private saving when the government implements expansionary fiscal policy. This might happen if consumer confidence rises following expansionary fiscal policy as shown by Bachman and Sims (2012). Figure 3 around here
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Kim (2015) reported real depreciations in response to the government consumption shock using a panel VAR framework for developed countries. He reported somewhat mixed evidence as to its effect on the trade account balance. 10 We obtained qualitatively very similar estimates when quadratic trend term is added to those deterministic terms. All results are available upon request. 11 The “total” investment is the sum of the private sector gross investment and the government gross investment. It is ideal to use the private investment, but the data availability is limited for the post-2000 period. 12 All results are available from authors upon requests.
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This strong evidence in favor of the twin deficit hypothesis disappears when we use the post2000 observations as can be seen in Figure 4. Responses of nxtt to the government consumption shock are overall significantly positive, although weaker than those from the earlier sample period. When fiscal spending shock occurs, the trade account balance increases for a short-period of time followed by a short correction, then go up again for over 5 years. We obtained very similar OIRF estimates from a VAR model with the current account balance (curt ) that replaces nxtt . Interestingly, Kim and Roubini (2008) also find similar short-run improvement of the current account balance to the fiscal shock for the US. 13 That is, we observe this so-called twin divergence only for the sample period when Korea transitioned into a highly market oriented economy after Korea’s foreign exchange crisis in late 1990’s. Responses of other variables, cont , nirt , and πt are qualitatively similar as those from the earlier observations.
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We also investigate this evidence of a structural break in the effect of the fiscal spending shock on the trade account balance via the forecast error variance decomposition (FEVDEC) analysis for nxtt . Results are reported in Figure 5. The most notable finding is that govt plays an important role in explaining the k-period ahead forecast error variance for nxtt only in the pre-2000 era. That is, govt explains roughly 25% in the long-run, which is the second important factor next to cont . However, govt ’s role becomes negligible in the post-2000 period. That is, the share of govt falls to around 10% in the long-run. Putting it differently, the effect of the government spending shock becomes a minor factor in predicting the trade account balance in a more market oriented Korean economy since 2000. That is, the FEVDEC analysis is also consistent with our findings on a structural break reported earlier. Also, we notice that cont has been always an important factor in explaining variations in future nxtt . This is because that cont moves in tandem with the total GDP. Replacing nxtt with the GDP yields qualitatively similar results.14 We also note that the nominal interest rate (nirt ) plays an important role in the latter sample period as its share increases from around 3% to 19%. This may reflect a drastic overhaul of financial regulatory system in Korea since the outburst of the Korean Financial Crisis in late 1990’s, which eliminated direct regulations of market interest rates. When interest rates are mainly determined by the market, nirt may play an important role in explaining the trade account via its effect on the nominal exchange rate, thus the real exchange rate. 15 Figure 5 around here
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We further investigate this issue by estimating the time-varying relationship between govt and nxtt . For this, we employ a 20-year fixed-size rolling window scheme for our VAR model in (1). That is, we repeatedly estimate the OIRFs with a 20-year memory window starting from 1980:I, which helps identify possible structural changes in the data generating process if any. The first column in Figure 6 provides three-dimension surface graphs for the OIRF of the trade account balance and the real exchange rate to the government spending shock. Similar estimates with the current account balance are reported in the second column. Light colored areas of the response functions indicate negative responses, while darker areas are positive responses. The first set of the response function estimates on the Date 2000 are obtained from observations between 1980:I and 1999:IV, while the last response function estimates on Date 2015 come from the sample period from 1996:II to 2015:I. The surface graph of the trade account as well as that of the current account balance clearly show that empirical evidence in favor of the twin deficit hypothesis disappears when estimations are implemented with newer observations. In fact, when the last set of 20-year long observations are used, the response function of nxtt remains positive since the impact, implying that expansionary fiscal policy improves the trade account balance. The current account balance also overall increases in response to the fiscal shock, which is consistent with the twin divergence hypothesis. The lower panel graphs exhibit dramatic changes in the response of the real exchange rate to the government spending shock in both VAR models. Response surface functions are qualitatively very 13 They use the government deficit, government spending minus the tax revenue, to identify the fiscal spending shock. We also implemented similar investigations replacing the government consumption with the government deficit. Results were very similar and are available upon requests. 14 Results are available upon requests. 15 Higher nominal interest rates imply a greater return on the domestic currency, which tends to result in appreciations of the currency.
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Figure 6 around here
4 4.1
Further Discussion Changes in Exchange Rate Regimes
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similar whether we use the trade account or the current account in the VAR model. These findings are consistent with those of Kim (2015) who reported strong panel evidence of real depreciations in response to fiscal shocks in developed countries under the flexible exchange rate regime. Overall, we obtain solid evidence that the fiscal spending shock tends to generate real appreciations of Korean won in the earlier period, whereas it yields real depreciations in the latter sample period.
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Previous section presented a possibility of a structural break in the propagation of fiscal policy to the trade account around the year 2000. This subsection discusses possible explanations on this issue in relation to a change in foreign exchange rate regimes in Korea around that period of time. It is well-known that Korea had maintained a tightly managed foreign exchange rate system until Korea’s foreign exchange crisis in 1997. Korea’s exchange rate policy has focused mainly on the US dollar exchange rate because most Korea’s international trade was conducted in the US dollar. As can be seen in Figure 7, the US dollar exchange rate, Korean won price of 1 US dollar, exhibits steady long swings around 800 until Korea got hit by massive speculative attacks in 1997. Similar pattern can be also observed in the HP cyclical (business cycle) component. Since this foreign exchange crisis, Korean government pursued a major economic overhaul based on recommendations of the International Monetary Fund (IMF) that provided a bailout program. Especially, Korea’s foreign exchange rate regime has transitioned from a tightly managed float system to a more market-oriented floating exchange rate system. Further, Korean government granted foreign investors broad access to domestic financial markets. See Dooley, Dornbusch, and Park (2002) for detailed explanations. Figure 7 around here
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In order to appraise the impact of this change in exchange-rate regimes on our analysis, we implemented VAR estimations for the two sub-sample periods, 1980:I to 1996:IV (Pre-Crisis) and 2000:I to 2015:I (Post-Crisis). We report responses of the dollar exchange rate, which is transformed to the (log) dollar price of one unit of Korean won to be consistent with our previous analysis. Results are reported in Figure 8. We first note that the response of the dollar exchange rate is a lot weaker in the pre-crisis period than in the post-crisis period, which is consistent with the regime change in Korea’s exchange rate system. Inflation rises in response to the fiscal spending shock immediately in the pre-crisis period and with a lag in the later period, which generates an upward pressure to the real exchange rate of Korean won. Nominal interest rates move in accordance with inflation, confirming the Fisher effect. In the pre-crisis period, Korean won appreciates slightly, though overall insignificantly, reflecting an increase in the nominal interest rate. Note that inflation rises in response to the fiscal spending shock, leading towards a real appreciation of Korean won. Real appreciations then deteriorate the trade account balance. In the post-crisis period, we noticed that Korean won depreciates substantially in response to unexpected increases in the government spending. After a brief recovery, which is statistically insignificant, Korean won overall stays depreciated for a while. As can be seen in Figure 8, the responses of the nominal dollar exchange rate dominate the responses of inflation, resulting in real depreciations of Korean won in response to the fiscal spending shock, which explains an improvement of the trade account balance in the later period. Figure 8 around here
Taken all together, this change in the exchange rate regimes in Korea implies a stronger role of the nominal exchange rate in determining the real exchange rate in the post-crisis period, and provide an explanation on our empirical evidence in favor of the twin deficit hypothesis only for the pre-2000 era, but not for the post-2000 era.
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4.2
Robustness Analysis with Augmented VAR Models
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Lastly, we provide robustness check analysis via augmented VAR models with three additional macroeconomic variables: government tax receipts (taxt ), consumer sentiment (sentt ), and private investment (pinvt ). That is, we estimate OIRFs from the VAR specification in (1) and (3) with the following. ,
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where at is one of the three additional variables. These three variables are available from 2000:I, so we estimate and report OIRFs only for the post-2000 sample period. It should be noted that the ordering of at does not matter as long as it is placed next to govt , because we are interested only in the OIRFs to the government spending shock as explained in Section 2. Figure 9 reports responses of all 6 variables plus taxt to the fiscal spending shock. We note OIRFs in Figure 10 confirm our previous findings in Figure 5 even after controlling for the tax revenues. The trade account balance overall improves in response to the fiscal shock, and rert persistently declines resulting in significant real depreciations. taxt increases after about a half-year delay. To understand why, we look at the response of cont that is highly positively correlated with the private GDP. It seems that the fiscal spending shock stimulates private activity as can be seen in persistent and significant increases in cont for about two years. Increases in tax revenues imply a sustainable fiscal stimulus policy in Korea because such endogenous increases in taxt would help balance the government budget.16 Figure 9 around here
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Figure 10 presents OIRF’s from a VAR model that employs at = sentt . Results again confirm our findings in Figure 4. We obtain strong evidence that shows an improvement of the trade balance (and the twin divergence) as well as real depreciations of Korean won when the fiscal shock occurs. The response of sentt implies that consumers become optimistic in the short-run when govt increases unexpectedly, which might explain the increases in cont . Bachman and Sims (2012) also reported similar consumer optimism in response to the expansionary fiscal shock during recessions in the US, while Jia and Kim (2016a) argue that fiscal spending shocks tend to generate consumer pessimism using an array of alternative identification schemes.
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Lastly, we employed at = pinvt and report OIRFs in Figure 11. Interestingly, the response of pinvt exhibits a mirror image of the response of the nxtt . This is consistent with the response of curt (available upon requests) that implies the twin divergence. Since cont increases when the fiscal spending shock occurs, domestic saving, both the private and the public saving, must decrease. Then, investment must fall by more than savings to be consistent with an improvement of the current account balance.
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Conclusion
This paper investigates the effects of the fiscal expansion shock on the trade account balance in Korea using an open economy VAR model framework. Finding a strong empirical support for the twin divergence hypothesis may imply that fiscal expansions can be an effective tool to stimulate the economy during recessions for a small open economy like Korea. The twin deficit hypothesis, however, suggests that policy makers should be cautious in implementing expansionary fiscal policy 16 We also implemented similar analysis using the fiscal deficit variable, which is the government consumption minus tax. That is, instead of using it as a separate control variable, tax is incorporated to the policy variable. We obtained similar results that are available upon requests. We also used the government investment instead of the government consumption for a policy variable. Again, we obtained similar findings and results are available upon requests.
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because it may deteriorate the trade account balance, which may not be negligible cost for a small open economy. Our impulse-response function analysis reveals a time-varying relationship between the government spending and the trade account balance over time. We obtained persistent and statistically significant decreases of the trade account balance as well as the current account balance with the pre-2000 sample period, whereas the trade account balance overall improves when we use the post-2000 data, which confirms the finding by Jeong, Kang, and Kim (2017). We explain this structural break as follows. Korea has implemented a drastic overhaul in financial system since its foreign exchange crisis in 1997-98, which resulted in more market-oriented financial markets since then. For instance, Korea discarded their tightly managed float exchange rate system following the IMF’s recommendation, and transitioned to a free floating system after the crisis. Inflation responds positively to the fiscal expansion shock, resulting in an upward pressure on the real exchange rate. Sluggish adjustments of the nominal exchange rate under the managed float system result in real appreciations in response to the government spending shock, followed by deteriorations of the trade account balance. On the contrary, the nominal exchange rate depreciated sharply when the fiscal spending shock occurs in the post-2000 era, which overall dominated inflation effects on the real exchange rate, resulting in an improvement in the trade account balance. In addition, we employed a smooth transition VAR model via a 20-year fixed-size rolling window scheme. That is, we investigated time-varying fiscal policy effects on the real exchange rate and on the trade/current account balance under the rolling window scheme. Results again strongly confirm the existence of the aforementioned structural break. We also implemented an array of extended VAR models that confirm our major findings for the post-2000 sample period. We further report evidence of effective fiscal policy in stimulating private spending in Korea via the OIRFs of consumption, consumer sentiment, and the government net tax.
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Reference
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1. Bachmann, R. and E. Sims (2012), ”Confidence and the Transmission of Government Spending Shocks,” Journal of Monetary Economics 59(3), 235-249. 2. Baxter, M. (1995), ”International Trade and Business Cycles,” In: Grossmann, G.M., Rogoff, K. (Eds.), Handbook of International Economics, vol. 3. Amsterdam, North-Holland, 18011864.
3. Beetsma, R., M. Giuliodori, and F. Klaassen (2008), ”The Effects of Public Spending Shocks on Trade Balances and Budget Deficits in the European Union,” Journal of the European Economic Association 6, 414-423.
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4. Christiano, L.J., M. Eichenbaum, and C.L. Evans (1999), ”Monetary Policy Shocks: What Have We Learned and to What End?,” in: J.B. Taylor and M. Woodford (ed.), Handbook of Macroeconomics volume 1, chapter 2, 65-148, Elsevier.
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5. Corsetti, G. and G.J. M¨ uller (2008), ”Twin Deficits, Openness, and the Business Cycle,” Journal of the European Economic Association 6, 404-413. 6. Dooley, M., R. Dornbusch, and Y.C. Park (2002), ”A Framework for Exchange Rate Policy in Korea,” Finance Working Papers 21757, East Asian Bureau of Economic Research. 7. Enders, Z., M¨ uller, G.J., and A. Scholl (2011), ”How do Fiscal and Technology Shocks affect Real Exchange Rates? New Evidence for the United States,” Journal of International Economics 83(1), 53-69. 8. Erceg, C.J., L. Guerrieri, and C. Gust (2005), ”Expansionary Fiscal Shocks and the U.S. Trade Deficit,” International Finance 8 (3), 363-397. 9. Hodrick, R. and E. Prescott (1997), ”Postwar U.S. Business Cycles: Investigation,” Journal of Money, Credit, and Banking 29 (1), 1-16.
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10. Ilzetzki, E., E. G. Mendoza, and G. A. Vegh (2013), “How Big (Small) Are Fiscal Multipliers?,”Journal of Monetary Economics 60, 239–254.
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11. Jeong, M., J. Kang, and S. Kim (2017), ”Effects of Government Consumption shocks in China, Japan, and Korea,” China Economic Journal 10, 194-225. 12. Jia, B. and H. Kim (2016a), ”Government Spending Shocks and Private Activity: The Role of Sentiments,” MPRA Working Paper No. 71554.
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13. Jia, B. and H. Kim (2016b), ”Fiscal Expansions and the Current Account in the US:: The Role of Sentiments,” manuscript.
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14. Kim, C., and D. Kim (2006), ”Does Korea Have Twin Deficits?” Applied Economics Letters 13, 675-680. 15. Kim, S. and N. Roubini (2008), ”Twin Deficit or Twin Divergence? Fiscal Policy, Current Account, and the Real Exchange Rate in the U.S.,” Journal of International Economics 74, 362-384. 16. Kim, S (2015), ”Country Characteristics and the Effects of Government Consumption Shocks on the Current Account and Real Exchange Rate,” Journal of International Economics 97, 436-447. 17. Kollmann, R. (1998), ”U.S. Trade Balance Dynamics: The Role of Fiscal Policy and Productivity Shocks and of Financial Market Linkages,” Journal of International Money and Finance 17, 637–669. 18. Kollmann, R. (2010), ”Government Purchases and the Real Exchange Rate,” Open Economies Review 21, 49-64.
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govt 1.000 −0.045 −0.273 −0.189 0.342
govt gdpt curt nxtt rert
govt 1.000 −0.131 0.011 0.011 −0.272
1.000 rert
1.000 −0.481 1.000 −0.710 0.811 1.000 0.392 −0.613 −0.629 2000:I-2015:I gdpt curt nxtt 1.000 −0.590 −0.627 0.523
1.000 0.696 −0.434
1.000 rert
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govt gdpt curt nxtt rert
1.000 −0.496 1.000 −0.694 0.777 1.000 0.412 −0.555 −0.602 1980:I-1999:IV gdpt curt nxtt
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govt 1.000 −0.066 −0.188 −0.138 0.157
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govt gdpt curt nxtt rert
Table 1: Correlation Estimations 1980:I-2015:I gdpt curt nxtt rert
1.000 −0.551
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Note: We used the Hodrick-Prescott cyclical components of the data with a smoothing parameter of 1600 for quarterly data.
Figure 1: Hodrick-Prescott Cyclical Components of the Data
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Note: We extracted the cyclical components of the data via the Hodrick-Prescott filter with a smoothing parameter of 1600 for quarterly data.
19. Mankiw, G. (2014), Principles of Macroeconomics, South-Western College Publication.
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20. M¨ uller, G.J. (2008), Understanding the Dynamic Effects of Government Spending on Foreign Trade,” Journal of International Money and Finance 27, 345-371. 21. Ramey, V.A. (2011), ”Identifying Government Spending Shocks: It’s All in the Timing,” Quarterly Journal of Economics 126(1), 1-50.
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22. Ravn, M.O., S. Schmitt-Groh´ e, and M. Uribe (2007), ”Explaining the Effects of Government Spending Shocks on Consumption and the Real Exchange Rate,” NBER Working Papers 13328, National Bureau of Economic Research.
Figure 2: IRF Estimates to the Fiscal Spending Shock: 1980:I-2015:I Note: We obtained one standard deviation confidence bands (dashed lines) by 500 nonparametric bootstrap simulations.
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Figure 3: IRF Estimates to the Fiscal Spending Shock: 1980:I-1999:IV
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Note: We employed the first 80 observations to estimate the fiscal spending shock effects. Dashed lines are 95% confidence bands obtained from 500 nonparametric bootstrap simulations.
Figure 4: IRF Estimates to the Fiscal Spending Shock: 2000:I-2015:I
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Note: We employed the last 80 observations to estimate the fiscal spending shock effects. Dashed lines are 95% confidence bands obtained from 500 nonparametric bootstrap simulations
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Figure 5: Forecast Error Variance Decomposition of the Trade Account Balance
Figure 6: Fiscal Spending Shock Effects: Fixed-Size Rolling Window Scheme Note: We repeat estimations of the impulse-response functions using a 20-year fixedsize rolling winodws scheme.
Figure 7: US Dollar Exchange Rates
Figure 8: IRF Estimates to the Fiscal Spending Shock for the Pre- and the Post-Crisis Periods
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Note: The sample period is between 1980:I and 1996:IV for the pre-crisis period, whereas the post-crisis period is between 2000:I and 2015:I. We obtained one standard deviation confidence bands (dashed lines) by 500 nonparametric bootstrap simulations.
Figure 9: IRF Estimates to the Fiscal Spending Shock with Tax Revenues
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Note: The sample period is between 2000:I and 2015:I. We obtained one standard deviation confidence bands (dashed lines) by 500 nonparametric bootstrap simulations.
Figure 10: IRF Estimates to the Fiscal Spending Shock with Consumer Sentiment
Note: The sample period is between 2000:I and 2015:I. We obtained one standard deviation confidence bands (dashed lines) by 500 nonparametric bootstrap simulations.
Figure 11: IRF Estimates to the Fiscal Spending Shock with Private Investment
Note: The sample period is between 2000:I and 2015:I. We obtained one standard deviation confidence bands (dashed lines) by 500 nonparametric bootstrap simulations.
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PII:
S1059-0560(17)30314-3
DOI:
10.1016/j.iref.2017.10.001
Reference:
REVECO 1504
To appear in:
International Review of Economics and Finance
Received Date: 18 April 2017 Revised Date:
27 September 2017
Accepted Date: 2 October 2017
Please cite this article as: Kim H. & Lee D., The effects of government spending shocks on the trade account balance in Korea, International Review of Economics and Finance (2017), doi: 10.1016/ j.iref.2017.10.001. This is a PDF file of an unedited manuscript that has been accepted for publication. As a service to our customers we are providing this early version of the manuscript. The manuscript will undergo copyediting, typesetting, and review of the resulting proof before it is published in its final form. Please note that during the production process errors may be discovered which could affect the content, and all legal disclaimers that apply to the journal pertain.
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∗ The views expressed herein are those of the authors and do not necessarily reflect the official views of the Bank of Korea. When reporting or citing this paper, the authors’ names should be explicitly stated. † Department of Economics, Auburn University, 217 Miller Hall, Auburn, AL 36849. Tel: (334) 844-2928. Fax: (334) 844-4615. Email: [email protected]. ‡ Economic Research Institute, Bank of Korea, Seoul, South Korea. Email: [email protected]
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October 6, 2017 Abstract
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Hyeongwoo Kim and Daeyup Lee
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The Effects of Government Spending Shocks on the Trade Account Balance in Korea
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This paper investigates fiscal policy effects on the trade account balance in Korea using open economy vector autoregressive (VAR) models. In response to fiscal spending shocks, real appreciations occur, followed by deteriorations in the trade account balance with the pre-2000 sample period, while real depreciations occur leading to an improvement in the trade account balance with the post-2000 sample period. We explain this structural break in relation to Korea’s transition from a tightly managed exchange rate regime to a more market-oriented floating system after Korea’s foreign exchange crisis in 1997-98. Furthermore, such fiscal policy effects from our post-2000 sub-sample imply that expansionary fiscal policy can be effective in stimulating private sector economy in Korea.
Introduction
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Keywords: Keywords: Fiscal Policy; Trade Account; Twin Deficit; Twin Divergence; Real Exchange Rate; VAR JEL Classification: E32; E62; F32; F41
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This paper empirically investigates the effects of fiscal expansions on the trade account balance in Korea using an open economy vector autoregressive (VAR) model. Specifically, we study how the trade account balance responds to government spending shocks through the propagation mechanisms of the shock to other key macroeconomic variables such as consumption and the real exchange rate in Korea. We often discuss fiscal policy effects on the current account balance and the trade account balance interchangeably, since dynamic responses of these two series to the fiscal shock are qualitatively similar. This is because their business cycle components, which are relevant to VAR analysis, tend to exhibit very high correlation, even when the raw data show sizable differences over time.1 Standard economic theories (e.g., Baxter, 1995; Kollman, 1998; Erceg, Guerrieri, and Gust, 2005) provide straightforward explanations for the so-called twin deficit hypothesis. When government spending increases with no matching increases in tax revenues (fiscal deficit), Ricardian consumers, rationally expecting a tax hike in the near future, reduce consumption (increase saving) and increase labor hours. As capital becomes more productive due to an increase in labor hours, investment rises which then offsets the increase in private saving. Therefore, the current account deteriorates (current account deficit), resulting in a twin deficit. On the other hand, most undergraduate level macroeconomics textbooks such as Mankiw (2014) provides an alternative but simpler explanation on the twin deficit hypothesis. As the government spending increases, national saving decreases, which results in an increase in the real interest rate. Higher real interest rate then attracts more capital toward the domestic capital market, resulting in a decrease in the net capital outflow. At the same time, the decrease in the net capital outflows
1 In the case of the US, the difference is very small, so the current account and the trade account are often used interchangeably.
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causes the real exchange rate to go up (real appreciation), which deteriorates the trade account balance. On the contrary, Kim and Roubini (2008) report a short-run improvement in the current account balance in response to the fiscal deficit shock using the current floating exchange rate regime data in the US. The real interest rate increases as the public saving decreases, which then lowers private investment. Private saving rises due to a decrease in consumption. Overall, the increase in private saving and the decrease in domestic investment jointly outweigh the decrease in public saving, leading to an improvement in the current account balance. They named this empirical finding the twin divergence hypothesis. Their model, however, does not explain why the real exchange rate depreciates, which is crucial to explain the improvement in the trade account balance, even though the real interest rate increases in their model in response to a positive fiscal shock. Jia and Kim (2016b) revisit this issue introducing the role of consumer sentiment. Their VAR model estimates imply that private spending declines as the fiscal shock generates consumer pessimism. That is, unexpected increases in the fiscal spending confirm incoming decreases in productivity in the near future (news effect). Anticipating recessions, private sector agents reduce both private consumption and investment. Unlike Kim and Roubini (2008), they report a decrease in the real interest rate, which then results in a real depreciation. The trade account balance improves accordingly. Therefore, their work confirms Kim and Roubini’s (2008) twin divergence hypothesis, though their model also explains why the real exchange rate depreciates leading to an improvement in the trade account balance as well. In addition to these studies, M¨ uller (2008), Corsetti and M¨ uller (2008), Ravn, Schmitt-Groh´ e, and Uribe (2007), Beetsma, Giuliodori, and Klaassen (2008), Kollman (2010), Enders, M¨ uller, and Scholl (2011), and Kim (2015) also investigated fiscal policy effects on the real exchange rate (terms of trade) and/or the trade account balance. In the present paper, we study the fiscal policy propagation mechanism from Korean experiences that adds new insights to the current literature. Among earlier related research work, Kim and Kim (2006) implemented the Granger Causality test for the government budget balance, the current account balance, and the exchange rate using Korean data. Unfortunately, their empirical findings are not very informative.2 We employ open economy VAR models for quarterly observations from 1980:I to 2015:I to investigate how fiscal shocks influence the trade account in Korea. We obtained strong evidence of a structural break in the dynamic relationship between the government spending and the trade account balance around the year 2000 when Korea completed economic overhauls since Korea’s foreign exchange crisis in the late 1990’s. The trade account balance deteriorates in response to the fiscal spending shock only when we employ the pre-2000 data. We obtained similar responses of the current account balance, which is consistent with the twin deficit hypothesis. With the post-2000 sample period, however, the trade account balance improves in response to the fiscal shock, which is similar to the US evidence reported by Kim and Roubini (2008). That is, in contrast to previous results, we observed real depreciations that improved the trade account balance. We noticed that Jeong, Kang, and Kim (2017) reported similar findings for Korea and Japan in their three-country study for China, Korea, and Japan. That is, they also reported a structural break in the response of the trade account balance to the government spending shock in Korea. However, they are primarily interested in comparing the fiscal policy effects/multipliers in the three countries.3 On the other hand, we focus on the fiscal policy effects on the trade (current) account balance in Korea using various models and specifications. Furthermore, we provide detailed explanations on what caused this structural break in sections 3.3 and 4.1. Korea has undergone a major overhaul since its financial crisis in 1997-98. In what follows, we clarify the role of more flexible prices in financial markets in understanding our findings about fiscal policy effect on the trade account in 2 They report that the fiscal balance fails to Granger cause the current account, whereas the current account Granger cause the fiscal budget. Since Granger Causality does not imply causal relationships, their findings provide not much useful information as to the validity of the twin deficit hypothesis in Korea. 3 In a similar study, Ilzetzki, Mendoza, and Vegh (2013) reported that the fiscal multiplier tends to be large in economies under the fixed exchange rate regime. For countries with flexible exchange rates, however, they reported a negative fiscal multipliers both in the short- and in the long-run, which is in sharp contrast with results of Jeong, Kang, and Kim (2017) who found substantial and significantly positive output effects of fiscal policy for Korea and Japan during flexible exchange rate regimes.
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The Empirical Model
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Korea, relating it to Korea’s transition to a market oriented exchange rate regime after the crisis. In response to fiscal policy shocks, substantial nominal depreciations occur dominating rising domestic inflation rate, resulting in real depreciations under the flexible exchange rate regime in the 2000’s but not in the pre-2000 sample period. We also implement an array of robustness check analysis which confirm our major findings from the baseline model. Also, using the post-2000 data, we provide some evidence of effective fiscal policy in stimulating private activity in Korea via responses of consumption, consumer sentiment, and government tax receipts. The rest of the paper is organized as follows. Section 2 describes the econometric model. Section 3 provides data descriptions and preliminary analysis, then we report our major empirical findings. Section 4 provides further discussions and robustness check analysis. Section 5 concludes.
We employ the following pth order vector autoregressive (VAR) model for open macroeconomy data in Korea. Abstracting from deterministic terms,
where xt =
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gt
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zt
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xt = Φ1 xt−1 + Φ2 xt−2 + · · · + Φp xt−p + Cut ,
(1)
and C is a lower-triangular matrix and ut is a vector of mutually orthonormal structural shocks, 0 that is, Eut ut = I.4 Our key variable gt denotes a measure of the government spending (govt ) such as the government consumption. For our baseline model, zt is the following. zt =
yt
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nirt
πt
rert
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(2)
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where yt is a private spending variable such as private consumption (cont ) or private investment (ivtt ). nxtt is the trade account balance as a share of the total GDP.5 nirt is the nominal interest rate and πt denotes the inflation rate. Lastly, rert denotes the real effective exchange rate. We demean and detrend xt prior to estimations. We are particularly interested in the j-period ahead orthogonalized impulse-response functions (OIRF) of zt to the government spending shock, defined as follows. IRF (j) = E (zt+j |ug,t = 1, Ωt−1 ) − E (zt+j |Ωt−1 ) ,
(3)
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where ug,t is the structural shock to gt in (1) and Ωt−1 is the adaptive information set at time t − 1.6 Note that gt is ordered first in xt , meaning that the fiscal policy variable is not influenced by other variables in zt within one quarter. This assumption is often employed in the current fiscal policy literature (e.g., Ramey, 2011), which seems to be an innocuous assumption, because implementation of discretionary fiscal policy normally requires congressional approval. It is well documented that econometric inferences based on recursively identified VAR models might not be robust to alternative VAR orderings. Our major findings, however, are not subject to this problem. As Christiano, Eichenbaum, and Evans (1999) show, all response functions to the fiscal spending shock are invariant because gt is ordered first. Put it differently, all response functions to the fiscal shock are numerically identical even when one randomly rearranges variables in zt .
4 We employed an intercept and linear time trend for our VAR estimations. Our estimates are qualitatively very similar when we add quadratic trend term to those deterministic terms. 5 We also employ the current account balance (curt ) instead of the nxtt , which yielded qualitatively similar results. 6 That is, the information set has the following property, Ωt−1 ⊇ Ωt−2 ⊇ Ωt−3 ⊇ · · ·.
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3 3.1
Empirical Results Data Description
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We obtained all data from the Bank of Korea unless stated otherwise. Observations are quarterly and span from 1980:I to 2015:I. nxtt is the trade account balance as a share of the total GDP (gdpt ), which is the exports (extt ) of goods and services minus the imports (imtt ) of goods and services. The current account balance (curt ) is also defined as a share of gdpt . All public and private spending variables, the government consumption (govt ), the private consumption (cont ), and the total investment (ivtt ), are divided by the GDP deflator, then logtransformed. The BIS real effective exchange rate (rert ) is obtained from the FRED and logtransformed. The nominal interest rate (nirt ) is the money market interest rate, obtained from the IFS CD-ROM. We obtained the core Consumer Price Index (CPI) inflation rate from the same source. Our baseline VAR models utilize govt to identify the fiscal spending shock. In the current literature, however, researchers have employed alternative measures of the fiscal spending variables such as the government budget balance (or deficit) or the government net tax to control for the tax effect. Unfortunately, the real net tax (taxt ) data is available only for the sample period that begins in 2000:I. In what follows, however, we show that empirical evidence from an extended VAR model with taxt provides qualitatively similar results. And Kim (2015) discussed the benefits of using the government consumption shock in the current literature of the twin deficit/divergence. Therefore, our identification strategy with the government consumption seems to the best option available for a Korean case study, even though it is not an ideal choice.
Preliminary Analysis
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Figure 1 reports the Hodrick-Prescott (HP) cyclical (business cycle) components of our key variables: government consumption (govt ), total GDP (gdpt ), the current account balance (share of GDP; curt ), the trade account balance (share of GDP; nxtt ), and the real effective exchange rate (rert ).7 We also report correlations of these variables in Table 1. Some of notable findings are as follows. First, we find empirical evidence of counter-cyclical fiscal policy in Korea only for the post-2000 sample period (2000:I-2015:I). When the economy enters a period of recession, government may implement expansionary fiscal policy that may come in the form of increased government spending. As the economy improves, the government may switch to contractionary policy to reduce its fiscal deficit and possibly to dampen inflationary pressure. In the pre-2000 era (1980:1-1999:IV), however, the correlation between govt and gdpt was negligibly small (−0.045), whereas it has increased to −0.131 in absolute value during the post-2000 era. That is, we find an substantial role of output stabilization in the conduct of fiscal policy in Korea only from observations since 2000.
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Table 1 around here
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Second, as we can clearly see in Figure 1, curt and nxtt exhibit very strong co-movement. The correlations were consistently high, 0.777, 0.811, and 0.696 in the full, the pre-2000, and the post2000 sample periods, respectively.8 On the other hand, nxtt (or curt ) and rert move in opposite directions, which is not surprising. Correlations were −0.602, −0.629, and −0.551 in the full, the pre-2000, and the post-2000 sample periods, respectively. In response to a sharp real depreciation triggered by Korea’s foreign exchange crisis in 1997, nxtt and curt both exhibit an abrupt and rapid hike. Similar dramatic changes are observed in around 2008 when the US Financial Crisis began, triggered by the collapse of Lehman Brothers in September 2008. We also note that nxtt exhibit counter-cyclical movements. That is, it seems that the trade account balance tends to improve in Korea during recessions. This is not necessarily an improvement, however, because Korean imports tend to fall more than exports during global recessions. Most importantly, we obtained negative correlation between govt and nxtt (or curt ) only from the pre-2000 era, while very small positive correlation was observed when we use the post-2000 observations. As we discussed before, Baxter (1995), Kollman (1998), and Erceg, Guerrieri, and 7 We set the smoothing parameter at 1,600 following the suggestion for quarterly data by Hodrick and Prescott (1997). 8 The difference between the current account and the trade account balance is the net amount received for domestically-owned factors of production used abroad.
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Figure 1 around here
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Gust (2005) among others predicted a deterioration of the current/trade account balance when there is a fiscal expansion shock (twin deficit ), whereas Kim and Roubini (2008) proposed an alternative hypothesis of the twin divergence based on their empirical findings for the post-war US data.9 That is, we observe evidence in favor of the twin deficit hypothesis from the pre-2000 sample period, while the data supports the twin divergence hypothesis for the latter sample period.
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To put in a nutshell, we obtained strong empirical evidence of a negative (static) relationship between the government spending and the trade account balance only for the earlier sample period. We also noticed a similar structural break between the government spending and the real exchange rate. In what follows, we investigate the dynamic effects of the fiscal expansion shock to the trade (and current) account balance in Korea using an array of open economy VAR models that are robust to alternative orderings.
Government Spending Shocks and the Trade Account
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We report dynamic responses of the trade account balance to the government spending (gt = govt ) shock via the orthogonalized impulse-response function (OIRF) estimate for the VAR model (1) and (2). We employed an intercept and linear time trend for estimations.10 Our benchmark model employs the private consumption (cont ) for the private spending yt . Using the total investment (invt ) instead produces qualitatively similar results.11 We also estimated the VAR model that replaces the trade account balance (nxtt ) with the current account balance (curt ), which again provided qualitatively similar results.12 All OIRF estimates are accompanied by one standard error confidence bands that are obtained by 500 nonparametric bootstrap simulations. Figure 2 provides strong empirical evidence of a negative dynamic relationship between the govt and nxtt from the full sample period. Since the impact, the trade account balance (nxtt ) starts to deteriorate persistently and significantly in response to the fiscal expansion shock. Initial adjustments are somewhat sluggish and the maximum response occurs in about 1.5 years. We also obtained quite similar dynamics for curt , which is consistent with the the twin deficit hypothesis. The real exchange rate exhibits persistent increases (real appreciations), which explains the negative responses of the trade account balance. The responses are overall statistically insignificant. It turns out, however, that this is due to pooling the two sub-sample periods together that generate qualitatively different responses of the real exchange rate to the fiscal shock.
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Figure 2 around here
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In Figures 3 and 4, we report OIRF estimates to the fiscal spending shock from the two subsample periods in order to investigate dynamic evidence of a structural break between govt and nxtt . When we employ the pre-2000 sample period, see Figure 3, the trade account balance decreases persistently and significantly in response to the fiscal spending shock, reaching the maximum response in around 1 year. Also, the fiscal spending shock yields real appreciations of Korean won, which explains the deterioration of the trade account balance. Both the nominal interest rate (nirt ) and inflation (πt ) rise when the fiscal shock occurs. It should be noted that private consumption (cont ) shows persistent increases that are highly significant, which is at odds with Ricardian consumers’ behavior. That is, consumers in Korea decrease private saving when the government implements expansionary fiscal policy. This might happen if consumer confidence rises following expansionary fiscal policy as shown by Bachman and Sims (2012). Figure 3 around here
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Kim (2015) reported real depreciations in response to the government consumption shock using a panel VAR framework for developed countries. He reported somewhat mixed evidence as to its effect on the trade account balance. 10 We obtained qualitatively very similar estimates when quadratic trend term is added to those deterministic terms. All results are available upon request. 11 The “total” investment is the sum of the private sector gross investment and the government gross investment. It is ideal to use the private investment, but the data availability is limited for the post-2000 period. 12 All results are available from authors upon requests.
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Figure 4 around here
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This strong evidence in favor of the twin deficit hypothesis disappears when we use the post2000 observations as can be seen in Figure 4. Responses of nxtt to the government consumption shock are overall significantly positive, although weaker than those from the earlier sample period. When fiscal spending shock occurs, the trade account balance increases for a short-period of time followed by a short correction, then go up again for over 5 years. We obtained very similar OIRF estimates from a VAR model with the current account balance (curt ) that replaces nxtt . Interestingly, Kim and Roubini (2008) also find similar short-run improvement of the current account balance to the fiscal shock for the US. 13 That is, we observe this so-called twin divergence only for the sample period when Korea transitioned into a highly market oriented economy after Korea’s foreign exchange crisis in late 1990’s. Responses of other variables, cont , nirt , and πt are qualitatively similar as those from the earlier observations.
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We also investigate this evidence of a structural break in the effect of the fiscal spending shock on the trade account balance via the forecast error variance decomposition (FEVDEC) analysis for nxtt . Results are reported in Figure 5. The most notable finding is that govt plays an important role in explaining the k-period ahead forecast error variance for nxtt only in the pre-2000 era. That is, govt explains roughly 25% in the long-run, which is the second important factor next to cont . However, govt ’s role becomes negligible in the post-2000 period. That is, the share of govt falls to around 10% in the long-run. Putting it differently, the effect of the government spending shock becomes a minor factor in predicting the trade account balance in a more market oriented Korean economy since 2000. That is, the FEVDEC analysis is also consistent with our findings on a structural break reported earlier. Also, we notice that cont has been always an important factor in explaining variations in future nxtt . This is because that cont moves in tandem with the total GDP. Replacing nxtt with the GDP yields qualitatively similar results.14 We also note that the nominal interest rate (nirt ) plays an important role in the latter sample period as its share increases from around 3% to 19%. This may reflect a drastic overhaul of financial regulatory system in Korea since the outburst of the Korean Financial Crisis in late 1990’s, which eliminated direct regulations of market interest rates. When interest rates are mainly determined by the market, nirt may play an important role in explaining the trade account via its effect on the nominal exchange rate, thus the real exchange rate. 15 Figure 5 around here
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We further investigate this issue by estimating the time-varying relationship between govt and nxtt . For this, we employ a 20-year fixed-size rolling window scheme for our VAR model in (1). That is, we repeatedly estimate the OIRFs with a 20-year memory window starting from 1980:I, which helps identify possible structural changes in the data generating process if any. The first column in Figure 6 provides three-dimension surface graphs for the OIRF of the trade account balance and the real exchange rate to the government spending shock. Similar estimates with the current account balance are reported in the second column. Light colored areas of the response functions indicate negative responses, while darker areas are positive responses. The first set of the response function estimates on the Date 2000 are obtained from observations between 1980:I and 1999:IV, while the last response function estimates on Date 2015 come from the sample period from 1996:II to 2015:I. The surface graph of the trade account as well as that of the current account balance clearly show that empirical evidence in favor of the twin deficit hypothesis disappears when estimations are implemented with newer observations. In fact, when the last set of 20-year long observations are used, the response function of nxtt remains positive since the impact, implying that expansionary fiscal policy improves the trade account balance. The current account balance also overall increases in response to the fiscal shock, which is consistent with the twin divergence hypothesis. The lower panel graphs exhibit dramatic changes in the response of the real exchange rate to the government spending shock in both VAR models. Response surface functions are qualitatively very 13 They use the government deficit, government spending minus the tax revenue, to identify the fiscal spending shock. We also implemented similar investigations replacing the government consumption with the government deficit. Results were very similar and are available upon requests. 14 Results are available upon requests. 15 Higher nominal interest rates imply a greater return on the domestic currency, which tends to result in appreciations of the currency.
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Figure 6 around here
4 4.1
Further Discussion Changes in Exchange Rate Regimes
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similar whether we use the trade account or the current account in the VAR model. These findings are consistent with those of Kim (2015) who reported strong panel evidence of real depreciations in response to fiscal shocks in developed countries under the flexible exchange rate regime. Overall, we obtain solid evidence that the fiscal spending shock tends to generate real appreciations of Korean won in the earlier period, whereas it yields real depreciations in the latter sample period.
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Previous section presented a possibility of a structural break in the propagation of fiscal policy to the trade account around the year 2000. This subsection discusses possible explanations on this issue in relation to a change in foreign exchange rate regimes in Korea around that period of time. It is well-known that Korea had maintained a tightly managed foreign exchange rate system until Korea’s foreign exchange crisis in 1997. Korea’s exchange rate policy has focused mainly on the US dollar exchange rate because most Korea’s international trade was conducted in the US dollar. As can be seen in Figure 7, the US dollar exchange rate, Korean won price of 1 US dollar, exhibits steady long swings around 800 until Korea got hit by massive speculative attacks in 1997. Similar pattern can be also observed in the HP cyclical (business cycle) component. Since this foreign exchange crisis, Korean government pursued a major economic overhaul based on recommendations of the International Monetary Fund (IMF) that provided a bailout program. Especially, Korea’s foreign exchange rate regime has transitioned from a tightly managed float system to a more market-oriented floating exchange rate system. Further, Korean government granted foreign investors broad access to domestic financial markets. See Dooley, Dornbusch, and Park (2002) for detailed explanations. Figure 7 around here
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In order to appraise the impact of this change in exchange-rate regimes on our analysis, we implemented VAR estimations for the two sub-sample periods, 1980:I to 1996:IV (Pre-Crisis) and 2000:I to 2015:I (Post-Crisis). We report responses of the dollar exchange rate, which is transformed to the (log) dollar price of one unit of Korean won to be consistent with our previous analysis. Results are reported in Figure 8. We first note that the response of the dollar exchange rate is a lot weaker in the pre-crisis period than in the post-crisis period, which is consistent with the regime change in Korea’s exchange rate system. Inflation rises in response to the fiscal spending shock immediately in the pre-crisis period and with a lag in the later period, which generates an upward pressure to the real exchange rate of Korean won. Nominal interest rates move in accordance with inflation, confirming the Fisher effect. In the pre-crisis period, Korean won appreciates slightly, though overall insignificantly, reflecting an increase in the nominal interest rate. Note that inflation rises in response to the fiscal spending shock, leading towards a real appreciation of Korean won. Real appreciations then deteriorate the trade account balance. In the post-crisis period, we noticed that Korean won depreciates substantially in response to unexpected increases in the government spending. After a brief recovery, which is statistically insignificant, Korean won overall stays depreciated for a while. As can be seen in Figure 8, the responses of the nominal dollar exchange rate dominate the responses of inflation, resulting in real depreciations of Korean won in response to the fiscal spending shock, which explains an improvement of the trade account balance in the later period. Figure 8 around here
Taken all together, this change in the exchange rate regimes in Korea implies a stronger role of the nominal exchange rate in determining the real exchange rate in the post-crisis period, and provide an explanation on our empirical evidence in favor of the twin deficit hypothesis only for the pre-2000 era, but not for the post-2000 era.
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4.2
Robustness Analysis with Augmented VAR Models
xt =
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Lastly, we provide robustness check analysis via augmented VAR models with three additional macroeconomic variables: government tax receipts (taxt ), consumer sentiment (sentt ), and private investment (pinvt ). That is, we estimate OIRFs from the VAR specification in (1) and (3) with the following. ,
(4)
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where at is one of the three additional variables. These three variables are available from 2000:I, so we estimate and report OIRFs only for the post-2000 sample period. It should be noted that the ordering of at does not matter as long as it is placed next to govt , because we are interested only in the OIRFs to the government spending shock as explained in Section 2. Figure 9 reports responses of all 6 variables plus taxt to the fiscal spending shock. We note OIRFs in Figure 10 confirm our previous findings in Figure 5 even after controlling for the tax revenues. The trade account balance overall improves in response to the fiscal shock, and rert persistently declines resulting in significant real depreciations. taxt increases after about a half-year delay. To understand why, we look at the response of cont that is highly positively correlated with the private GDP. It seems that the fiscal spending shock stimulates private activity as can be seen in persistent and significant increases in cont for about two years. Increases in tax revenues imply a sustainable fiscal stimulus policy in Korea because such endogenous increases in taxt would help balance the government budget.16 Figure 9 around here
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Figure 10 presents OIRF’s from a VAR model that employs at = sentt . Results again confirm our findings in Figure 4. We obtain strong evidence that shows an improvement of the trade balance (and the twin divergence) as well as real depreciations of Korean won when the fiscal shock occurs. The response of sentt implies that consumers become optimistic in the short-run when govt increases unexpectedly, which might explain the increases in cont . Bachman and Sims (2012) also reported similar consumer optimism in response to the expansionary fiscal shock during recessions in the US, while Jia and Kim (2016a) argue that fiscal spending shocks tend to generate consumer pessimism using an array of alternative identification schemes.
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Figure 10 around here
Figure 11 around here
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Lastly, we employed at = pinvt and report OIRFs in Figure 11. Interestingly, the response of pinvt exhibits a mirror image of the response of the nxtt . This is consistent with the response of curt (available upon requests) that implies the twin divergence. Since cont increases when the fiscal spending shock occurs, domestic saving, both the private and the public saving, must decrease. Then, investment must fall by more than savings to be consistent with an improvement of the current account balance.
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Conclusion
This paper investigates the effects of the fiscal expansion shock on the trade account balance in Korea using an open economy VAR model framework. Finding a strong empirical support for the twin divergence hypothesis may imply that fiscal expansions can be an effective tool to stimulate the economy during recessions for a small open economy like Korea. The twin deficit hypothesis, however, suggests that policy makers should be cautious in implementing expansionary fiscal policy 16 We also implemented similar analysis using the fiscal deficit variable, which is the government consumption minus tax. That is, instead of using it as a separate control variable, tax is incorporated to the policy variable. We obtained similar results that are available upon requests. We also used the government investment instead of the government consumption for a policy variable. Again, we obtained similar findings and results are available upon requests.
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because it may deteriorate the trade account balance, which may not be negligible cost for a small open economy. Our impulse-response function analysis reveals a time-varying relationship between the government spending and the trade account balance over time. We obtained persistent and statistically significant decreases of the trade account balance as well as the current account balance with the pre-2000 sample period, whereas the trade account balance overall improves when we use the post-2000 data, which confirms the finding by Jeong, Kang, and Kim (2017). We explain this structural break as follows. Korea has implemented a drastic overhaul in financial system since its foreign exchange crisis in 1997-98, which resulted in more market-oriented financial markets since then. For instance, Korea discarded their tightly managed float exchange rate system following the IMF’s recommendation, and transitioned to a free floating system after the crisis. Inflation responds positively to the fiscal expansion shock, resulting in an upward pressure on the real exchange rate. Sluggish adjustments of the nominal exchange rate under the managed float system result in real appreciations in response to the government spending shock, followed by deteriorations of the trade account balance. On the contrary, the nominal exchange rate depreciated sharply when the fiscal spending shock occurs in the post-2000 era, which overall dominated inflation effects on the real exchange rate, resulting in an improvement in the trade account balance. In addition, we employed a smooth transition VAR model via a 20-year fixed-size rolling window scheme. That is, we investigated time-varying fiscal policy effects on the real exchange rate and on the trade/current account balance under the rolling window scheme. Results again strongly confirm the existence of the aforementioned structural break. We also implemented an array of extended VAR models that confirm our major findings for the post-2000 sample period. We further report evidence of effective fiscal policy in stimulating private spending in Korea via the OIRFs of consumption, consumer sentiment, and the government net tax.
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Reference
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1. Bachmann, R. and E. Sims (2012), ”Confidence and the Transmission of Government Spending Shocks,” Journal of Monetary Economics 59(3), 235-249. 2. Baxter, M. (1995), ”International Trade and Business Cycles,” In: Grossmann, G.M., Rogoff, K. (Eds.), Handbook of International Economics, vol. 3. Amsterdam, North-Holland, 18011864.
3. Beetsma, R., M. Giuliodori, and F. Klaassen (2008), ”The Effects of Public Spending Shocks on Trade Balances and Budget Deficits in the European Union,” Journal of the European Economic Association 6, 414-423.
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4. Christiano, L.J., M. Eichenbaum, and C.L. Evans (1999), ”Monetary Policy Shocks: What Have We Learned and to What End?,” in: J.B. Taylor and M. Woodford (ed.), Handbook of Macroeconomics volume 1, chapter 2, 65-148, Elsevier.
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5. Corsetti, G. and G.J. M¨ uller (2008), ”Twin Deficits, Openness, and the Business Cycle,” Journal of the European Economic Association 6, 404-413. 6. Dooley, M., R. Dornbusch, and Y.C. Park (2002), ”A Framework for Exchange Rate Policy in Korea,” Finance Working Papers 21757, East Asian Bureau of Economic Research. 7. Enders, Z., M¨ uller, G.J., and A. Scholl (2011), ”How do Fiscal and Technology Shocks affect Real Exchange Rates? New Evidence for the United States,” Journal of International Economics 83(1), 53-69. 8. Erceg, C.J., L. Guerrieri, and C. Gust (2005), ”Expansionary Fiscal Shocks and the U.S. Trade Deficit,” International Finance 8 (3), 363-397. 9. Hodrick, R. and E. Prescott (1997), ”Postwar U.S. Business Cycles: Investigation,” Journal of Money, Credit, and Banking 29 (1), 1-16.
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10. Ilzetzki, E., E. G. Mendoza, and G. A. Vegh (2013), “How Big (Small) Are Fiscal Multipliers?,”Journal of Monetary Economics 60, 239–254.
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11. Jeong, M., J. Kang, and S. Kim (2017), ”Effects of Government Consumption shocks in China, Japan, and Korea,” China Economic Journal 10, 194-225. 12. Jia, B. and H. Kim (2016a), ”Government Spending Shocks and Private Activity: The Role of Sentiments,” MPRA Working Paper No. 71554.
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13. Jia, B. and H. Kim (2016b), ”Fiscal Expansions and the Current Account in the US:: The Role of Sentiments,” manuscript.
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14. Kim, C., and D. Kim (2006), ”Does Korea Have Twin Deficits?” Applied Economics Letters 13, 675-680. 15. Kim, S. and N. Roubini (2008), ”Twin Deficit or Twin Divergence? Fiscal Policy, Current Account, and the Real Exchange Rate in the U.S.,” Journal of International Economics 74, 362-384. 16. Kim, S (2015), ”Country Characteristics and the Effects of Government Consumption Shocks on the Current Account and Real Exchange Rate,” Journal of International Economics 97, 436-447. 17. Kollmann, R. (1998), ”U.S. Trade Balance Dynamics: The Role of Fiscal Policy and Productivity Shocks and of Financial Market Linkages,” Journal of International Money and Finance 17, 637–669. 18. Kollmann, R. (2010), ”Government Purchases and the Real Exchange Rate,” Open Economies Review 21, 49-64.
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govt 1.000 −0.045 −0.273 −0.189 0.342
govt gdpt curt nxtt rert
govt 1.000 −0.131 0.011 0.011 −0.272
1.000 rert
1.000 −0.481 1.000 −0.710 0.811 1.000 0.392 −0.613 −0.629 2000:I-2015:I gdpt curt nxtt 1.000 −0.590 −0.627 0.523
1.000 0.696 −0.434
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govt gdpt curt nxtt rert
1.000 −0.496 1.000 −0.694 0.777 1.000 0.412 −0.555 −0.602 1980:I-1999:IV gdpt curt nxtt
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govt 1.000 −0.066 −0.188 −0.138 0.157
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Table 1: Correlation Estimations 1980:I-2015:I gdpt curt nxtt rert
1.000 −0.551
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Note: We used the Hodrick-Prescott cyclical components of the data with a smoothing parameter of 1600 for quarterly data.
Figure 1: Hodrick-Prescott Cyclical Components of the Data
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Note: We extracted the cyclical components of the data via the Hodrick-Prescott filter with a smoothing parameter of 1600 for quarterly data.
19. Mankiw, G. (2014), Principles of Macroeconomics, South-Western College Publication.
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20. M¨ uller, G.J. (2008), Understanding the Dynamic Effects of Government Spending on Foreign Trade,” Journal of International Money and Finance 27, 345-371. 21. Ramey, V.A. (2011), ”Identifying Government Spending Shocks: It’s All in the Timing,” Quarterly Journal of Economics 126(1), 1-50.
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22. Ravn, M.O., S. Schmitt-Groh´ e, and M. Uribe (2007), ”Explaining the Effects of Government Spending Shocks on Consumption and the Real Exchange Rate,” NBER Working Papers 13328, National Bureau of Economic Research.
Figure 2: IRF Estimates to the Fiscal Spending Shock: 1980:I-2015:I Note: We obtained one standard deviation confidence bands (dashed lines) by 500 nonparametric bootstrap simulations.
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Figure 3: IRF Estimates to the Fiscal Spending Shock: 1980:I-1999:IV
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Note: We employed the first 80 observations to estimate the fiscal spending shock effects. Dashed lines are 95% confidence bands obtained from 500 nonparametric bootstrap simulations.
Figure 4: IRF Estimates to the Fiscal Spending Shock: 2000:I-2015:I
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Note: We employed the last 80 observations to estimate the fiscal spending shock effects. Dashed lines are 95% confidence bands obtained from 500 nonparametric bootstrap simulations
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Figure 5: Forecast Error Variance Decomposition of the Trade Account Balance
Figure 6: Fiscal Spending Shock Effects: Fixed-Size Rolling Window Scheme Note: We repeat estimations of the impulse-response functions using a 20-year fixedsize rolling winodws scheme.
Figure 7: US Dollar Exchange Rates
Figure 8: IRF Estimates to the Fiscal Spending Shock for the Pre- and the Post-Crisis Periods
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Figure 9: IRF Estimates to the Fiscal Spending Shock with Tax Revenues
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Note: The sample period is between 2000:I and 2015:I. We obtained one standard deviation confidence bands (dashed lines) by 500 nonparametric bootstrap simulations.
Figure 10: IRF Estimates to the Fiscal Spending Shock with Consumer Sentiment
Note: The sample period is between 2000:I and 2015:I. We obtained one standard deviation confidence bands (dashed lines) by 500 nonparametric bootstrap simulations.
Figure 11: IRF Estimates to the Fiscal Spending Shock with Private Investment
Note: The sample period is between 2000:I and 2015:I. We obtained one standard deviation confidence bands (dashed lines) by 500 nonparametric bootstrap simulations.
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