Evidence from Taiwan

Yu-Ning Hwang and Paul D. McNelis

June 28, 2012

Abstract

This paper applies counterfactual simulation experiments based on a calibrated model of an open-economy DSGE model for Taiwan. We assess the monetary targeting framework of the Central Bank of the Republic of China realtive to a …xed-rate system practiced in Hong Kong, a Taylor rule used in Korea, and an exchange-rate management policy used in Singapore. The welfare di¤erences are minimal, but the monetary rule of Taiwan delivers signi…cantly lower share market volatility for a variety of shocks.

JEL Classi…caltion: E52, E62,F41

1 Introduction

Since 1992 the Central Bank of the Republic of China (Taiwan) (thereafter CBC) has been o¢ cially targeting the growth rate of broad money through base money instruments. According to the “Purpose and Function of the CBC”

(CBC, 2006), the CBC generally adopts the framework of monetary targeting and chooses the monetary aggregate, M2, to be the intermediate target. It ap-pears that the Central Bank of the Republic of China (Taiwan) has thus bucked the trend of in‡ation targeting or exchange-rate managing among national mon-etary authorities in East Asia. Broad monmon-etary targets remain alive and well in Taiwan, despite the oft quoted phrase of John Crow, former Governor of the Bank of Canada , that we (central bankers) "have not abandoned monetary targets, they abandoned us"[see King (1996), p.4].

Elsewhere in the region, among the "Gang of Four", of South Korea, Hong Kong, and Singapore, there are di¤erent monetary regimes in place. The Cen-tral Bank of the Republic of Korea has adopted in‡ation targeting with ‡exible

Department of Economics, National Chengchi University, Taipei. EMail: [email protected]

yDepartment of Finance, Graduate School of Business Administration, Fordham University, New York 10019.. Email: [email protected]

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exchange rates and interest rate instruments after the East Asian crisis. By contrast, the Monetary Authority of Singapore has followed an exchange-rate targeting framework, while the Hong Kong Monetary Authority has maintained its currency board since 1984.

The issue of …xed vs. ‡exible exchane rates, of course, is an old one. A recent contribution, by Lahiri, Singh and Vegh (2007) has drawn attention to the role of asset market segmentation. We know that for real external shocks, and sticky prices, a ‡exible exchange-rate system dominates a …xed rate system, since exchange-rate ‡exibility enables relative price adjustment. For monetary shocks, the …xed rate dominates. However, under segmented assets markets, with ‡exible prices, the opposite result holds. Monetary shocks, due to frictions, imply relative price changes, which require exchange-rate changes, while real shocks, with ‡exible prices, do not need exchange-rate changes.

Of course most countries, especially emerging markets, have some degree of asset-market segmentation and some degree of price stickiness. Which type of exchange rate system works best?

This paper also draws attention to two types of ‡exible exchange-regimes, one with broad money targeting and one with in‡ation targeting.

In the past decade, in‡ation targeting rule has received wide attention.

Amid much debate about the causes of the Great Moderation, for example, Giannone, Lenza, and Reichlin (2008), argue that the underlying cause of the Great Moderation was more than good luck (due to favorable shocks). Rather, it was due to a change in the way the shocks were propagated, through the establishment of a better, more credible monetary policy framework. As noted by King (1996), while broad money targeting can provide credibility, in‡ation targeting is more direct, since it focuses on the ultimate target, and thus is more transparent. Since headline in‡ation is readily available to the public, accountability of central bank performance comes to the central of the stage in this framework.

While most of the countries operate interest rate rules, the monetary ex-periences of Taiwan have demonstrated that monetary targets work well. The macroeconomic fundamentals have remained relatively stable. A comparison be-tween Taiwan and Korea (which has implemented in‡ation targeting rule since 1998), in Table 1, shows that the standard deviations of the GDP growth rate, CPI in‡ation and share price in‡ation are lower in Taiwan than in Korea based during the 1998-2007 period. Based on the experience of these two fast grow-ing economies within the East Asia region, there is no empirical evidence that monetary targeting regimes fare worse than in‡ation-targeting regimes, …xed exchange-rate regimes, or exchange-rate management regimes.

Table 1:

Macroeconomic Volatility: Taiwan vs. South Korea

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Percentage Growth Rate:

GDP CPI Share Index Standard Deviation:

Taiwan 0.0169 0.0035 0.0777 South Korea 0.0553 0.0664 0.0898

To investigate this issue further, this paper investigates the bene…t and cost of the monetary targeting relative to a counterfactual in‡ation-targeting regime, as well as a …xed rate and a managed exchange-rate system, in Taiwan, with a dynamic stochastic general equilibrium models estimated with Bayesian meth-ods. A previous study by Hou (2005), using data between 1991 and 2003, found that a rule to control the growth rate of the reserve money outperformed the Taylor rule for stabilizing income and prices. Hou’s model was based on a relatively simple New Keynesian model and the results were based on para-meters estimated by classical methods. While the o¢ cial position of the CBC is that its policy comes from a monetary-targeting framework, Hsu (1999) ar-gued that the interest rate has been an important ancillary instrument, while Chen and Wu (2010) found some evidence of switching between interest and monetary-growth rate rules, but they argue that monetary aggregate rules can well characterize the monetary policy of the CBC before 1998. More recently, however Teo (2009) used Bayesian estimation of a DSGE model to test the hy-pothesis of a monetary-targeting regime against alternative regimes based on the Taylor rule or exchange-rate targeting. Based on posterior odds ratios, the evidence strongly favored the monetary targeting regime for Taiwan. While Teo’s work empirically establishes the use of the monetary targeting regime as the de facto policy framework of Taiwan, he did not perform any comparison of the macroeconomic performance of the de facto regime with counterfactual in‡ation or exchange-rate targeting regimes. This is the aim of this paper.

Scharnagl, Gerberding and Seitz (2010) argued that including broad money growth rates in a Taylor rule outperforms pure in‡ation targeting in a Taylor rule, for the Euro area. These authors make use of an estimated closed econ-omy New Keynesian framework. They base their argument on the reality of measurement error of real-time output used by central bank policy-makers, and thus output-gap uncertainty, in the pure Taylor-rule framework.

In contrast to Scharnagl, Gerberding, and Seitz, we use an open-economy model which includes investment and capital accumulation. We include the

…nancial sector for the liquidity injection by the central bank’s monetary ag-gregate policy with the targeted growth rate of reserve money. On the other hand, the counterfactual experiments focusing on the CPI in‡ation targeting, away from broad money targeting, neglected the asset price in‡ation during the period of the Great Moderation. One of the key results we show in this paper is that a monetary targeting framework delivers much lower volatility in To-bin’s Q, an indicator or shadow price of assets. Ironically, the focus on in‡ation targeting, which is more transparent and privdes accountability, is also more limited than broad money targeting in providing stability to the share prices in

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the economy and …nancial markets in general. The economy can be stabilized through the conrtol of the growth rate of broad money which is the primary source of liquidity to the economy.

Thus, the case of Taiwan may have given us a good example of monetary aggregate targeting as an alternative, perhaps "old-fashioned" monetary regime, especially after the widespread …nancial crisis which has raised questions about the advisability of in‡ation targeting with interest rate rules. The next section of the paper presents the model we use for calibration and simulation. We then discuss the numerical speci…cation of parameters, and shock processes. After that, we take up comparative policy simulations, for the base case of monetary targeting and for the counterfactual cases of …xed exchange rate, a Taylor rule, and exchange-rate management. Our results show that Taiwan would not necesarily be better o¤ if the Central bank followed the policy rules of the Hong Kong Monetary Authority, the Central Bank of Korea, or the Monetary Authority of Singapore.