KDI - Korea Development Institute - RESEARCH - Research Areas

Summary

Research Monograph KOR Establishing a Macroeconomic Model System Considering Changes in Economic and Social Structure

This report analyzes economic models from three perspectives to respond to the evolving macroeconomic environment. First, the COVID-19 crisis has substantially increased economic volatility and uncertainty, underscoring the need for timely assessment of economic conditions. However, the delayed release of major indicators like gross domestic product (GDP) limits real-time understanding. In this report, we test the performance of economic models by incorporating high-frequency data from private sources alongside traditional low-frequency data. As data accumulate throughout the concerned quarter, real-time forecasts converge closely with actual outcomes, demonstrating strong potential for real-time economic forecasting models.

Second, South Korea’s economy has likely experienced both short-term fluctuations and structural shifts following shocks such as the COVID-19 pandemic. Macroeconomic policies should address short-term volatility and structural shifts differently, yet structural changes are often unobservable. Therefore, macroeconomic models should estimate these unobservable factors for effective policy responses. This report constructs a model to estimate aggregate demand pressure, a cyclical indicator, and the real neutral interest rate, a key guide for determining monetary policy stance. The estimation results are discussed in detail.

Third, since peaking in 2019, Korea’s working-age population has been declining, with rapid demographic shifts driven by low birth rates and an aging population expected to continue. These demographic changes affect labor input and can be a major factor in slowing down economic growth. Also, long-term forecasts serve as baseline data for managing government finances and national pension funds. In this report, we use population estimates from Statistics Korea to project long-term economic growth rates through 2050. Scenario analyses for demographic changes and trends in total factor productivity are used to suggest policy directions for sustainable growth.

Summary

Research Monograph KOR Housing Market Regulations and Housing Supply: Focusing on LTV, DSR, Property Tax, and the Improvement of Pre-Sale Housing

The Korean government often implements financial regulations, such as the Loan-to-Value (LTV) and Debt-Service-Ratio (DSR), ratios, to stabilize the housing market. This study investigates the effectiveness of these policies in the housing market and, if effective, determines whether they enhance the utility for housing consumers.

Additionally, the government employs housing supply policies, which greatly impact the housing market. Housing provision is a lengthy and capital-intensive process. Korea supplies most of the new housing through a system known as the pre-sale policy. In fact, this system has consistently faced the challenge of overheating subscriptions for over 40 years. In light of the current housing market dynamics, Chapter 3 explores possible improvements to the existing housing supply policy.

As for the effect of financial regulation, the policy that lowers the upper limit of the LTV ratio from 70% to 40% reduces household loans by more than 31% while increasing the relative price of housing by 0.005%. If the upper limit on LTV ratios is lowered, households experience a low productivity shock, making it difficult to maintain consumption levels by increasing mortgage lending when incomes fall. As a result, they are motivated to increase savings. When the capital stock in the model economy increases due to the increase in household savings, the real interest rate falls. Wealthy households with relatively large amounts of assets reduce the share of financial assets in their asset portfolios and increase the share of housing because the real interest rate, which is the rate of return on investment in financial assets, has fallen.

The analysis in this study reveals that policies tightening household lending regulations do not effectively curtail housing prices in the long run. If the goal is long-term price stabilization, the study suggests that increasing the supply of new housing is more effective than suppressing housing demand through stricter lending regulations.

Lastly, the study proposes a new policy model for improving housing supply, especially for the younger demographic. This model seeks to address both the housing service and investment needs of younger people. Regarding public offerings and transactions of fractional ownership, housing demand is categorized into the demand for residential services and the demand for investment in housing assets. In the current pre-sale subscription method, the share of the house is divided, and public offering subscriptions are received. This method distributes shares to each subscriber in proportion to the competition rate for subscriptions. In this scenario, new housing is provided to young adults as rental properties in line with the existing subscription method to meet the need for residential demand.

Summary

Policy Study KOR Decline in the Expected Inflation and the Implications

Using the Phillips curve, this study estimates the long-term expected inflation and the degree of the anchoring of inflation to long-term expectations. The analysis finds that there have been drastic changes in the dynamics of inflation expectations since 2012. Long-term expectations fell to around 1%, hovering below the target. Moreover, inflation expectations are strongly anchored to long-term expectations, implying that the low inflation trend may persist for an extended time. This means that even if inflation rises temporarily, it can fall back to a low level that is short of the target.

Accordingly, support must be provided to stable economic activities while monetary policies are managed in a manner that helps the expected inflation settle within the target range. The monetary authorities need to rigorously analyze the structural changes that may be lying in wait underneath the surface of inflation dynamics, and reexamine the problems within the management system that could impede inflation stability. It is also worth considering a preemptive position when presenting policy directions, which can serve as a reminder of the authority’s strong commitment to inflation stability. Indeed, long-term inflation expectations could close in on the target while inflation settles within the target range when economic agents have a strong belief in this commitment.

Summary

Policy Study KOR A Welfare Analysis of Sustainable Pension Reforms

This paper employs a Life-Cycle Overlapping Generations Model to quantify the welfare impacts of plans to postpone the depletion of the National Pension Fund. In order for the model to fully incorporate the rapidly changing demographic structure of Korea, we build and calibrate a model in transition directly. The model is considered suitable for analyzing the effects of demographic changes on the Korean economy and the effects of plans to change the National Pension System. According to the model simulation, to postpone the depletion of the National Pension Fund for 30 years, the premium rate must be increased to 18.3% from the current rate of 9%. By postponing the depletion of the fund reserve, young and future generations gain significantly at the expense of the old generations. The simulation results should be, however, interpreted that the current system is unjustifiably partial to the old generations. Moreover, given the current premium rate, it is desirable to strengthen the income redistributing function of the National Pension System.

Summary

Policy Study KOR The Macroeconomic Effect of SME Policy in Korea

The proportion of small sized firms in Korea is relatively high compared to those of comparable countries such as Taiwan, as well as large economy such as the United States and Japan. However, small firms’ share of value added in Korea is lower than these countries. This means that despite the relatively low productivity of small businesses, it continues to operate. This seems to be related that Korea`s SME policy is highly supportive among OECD member nations.

This study examined the inefficiency of resource misallocation resulting from size-dependent policies. Establishing a general equilibrium model of two sectors that allow the career choice(the span-of-control), we investigate the changes in key aggregate variables if size-dependent policy is implemented in capital use. As a result, the capital, labor, productivity and output were declining in the economy of size-dependent policy. For example, output decreased by 4.2%~ 6.5% if capital tax increases more by 10% only for large firms. The firm size distribution is skewed to the left, so that the average number of employees decrease by 1.35~1.98. This negative effect is amplified in the case that the value added share of distorted sector is larger in the economy.

Summary

Policy Study KOR Tax Revenue Forecasts with Possible Structural Changes

During the past three consecutive years, over-estimations in forecasts of tax revenue have led to revenue shortfalls. These developments have motivated this study, which examines the current practices in tax revenue forecasting and the existing literature, and conducts tests for the presence of possible structural changes in tax revenue and other relevant time series. We then comparatively evaluate the performance of each forecasting model to select the best- performing models by tax item, using these to make 5-year forecasts for the revenues of the national tax and other key tax items.

While differences in political characteristics and budget processes across countries does not allow for a direct comparison, We find that the forecast errors for Korea’s tax revenue over the past decade are not particularly serious in terms of bias or instability when compared to that of other countries. Nevertheless, it is evident that the average bias has been widening recently, while the tax revenue has been overestimated by nearly 5% during the past three years.

To avoid the systematic over-estimation of tax revenue, it is important to consider the slowdown of tax revenue growth. We check the validity of the log linear system and strongly reject the log linear system. There is a clear sign of structural change in the linear trend or nonlinear trend in national tax revenue series and related macro series. However it is uncertain what kind of nonlinear trend is appropriate for the purpose of forecasting because several nonlinear specifications give similar in-sampling fit but make quite different out-sample forecasts.

We incorporate the element of structural breaks or nonlinear trend in making our forecasts through employing dummy variables, cubic spline models, exponential smoothing models, piecewise regression models combined with structural change tests, as well as a combination of the forecasting models. Because of the characteristics of each tax item’s data and the differences in the associated tax systems, different models were found to perform better for each tax item. For example, piecewise regression and exponential smoothing are effective for national tax revenue forecasting but vector autoregressive model and error correction model with dummy variables are best-performing for corporate tax revenue forecasting.

Due to the high possibility of recent structural changes in the national tax and corporate tax, the effects of such changes must be examined more closely. As there are still uncertainties regarding the existence of recent structural changes and their effects, using exponential smoothing models which take account of such uncertainties or a combination of models may contribute to gains in predictive power.

Along with the aforementioned technical treatment of tax revenue forecasting models, we would like to point out the necessity for a review of when the forecasts are made during the budget process. In addition to the fact that the circumstances in both the domestic and international economy, within which taxation must take place, have become increasingly complex, there have been calls for more accurate revenue forecasts to secure fiscal soundness. These developments suggest that we must reconsider whether it is adequate to present the 1-year horizon forecast (for individual tax items) when the budget is proposed to the National Assembly, and the 5-year horizon forecast (for the national tax) for the National Fiscal Management Plans. Rather than keeping revenue forecasts a one-off affair prior to the drawing up of the budget bill and its deliberation, making it an ongoing effort throughout the budget process and linking it to the next year’s budget process will allow for better amendment of errors and overall improvements in structural predictive power.

Summary

Policy Study KOR Testing Effects of Housing-Driven Stress Scenarios in Korea: Focusing on Sectoral Consequences

The housing sector in Korea is currently in transition due to various structural and environmental changes, including the accelerating population aging, the lowering potential GDP growth, and the shifting tenure choice patterns. Given these changes, the current study aims to quantify effects of housing market driven stress scenarios on four specific economic agents of relevancy: 75 listed construction companies, 17 commercial banks, 96 savings banks, and households (or borrowers of residential mortgage loans). We employ particular performance indicators for these agents (operational profit rates for the construction firms, capital ratios and non-performing loan -NPL- rates for the commercial banks, and NPL rates for the saving banks), and estimate a regression model for each of the indicators. In our empirical analyses, we use the quantile regression methods, which yield an interval, rather than point, estimation of the effect of each scenario tested.

As a summary, the results show that: as expected, the stress scenarios employed raise NPL rates of the commercial and saving banks but lower their capital ratios and the operational profit rates of the construction companies; as more micro evidences, the negative effects of the scenarios are more severe for smaller business entities as well as for lower-income and less creditworthy borrower cohorts. In addition, the quantile regression results demonstrate that the model selection bias tends to be large: for example, the NPL ratios of the commercial banks are shown to respond more sensitively with a higher-percentile quantile method, e.g., 2.71 percent increase (in response to a particular scenario) with a 50th percentile regression vs. 4.66 percent with a 95th percentile regression (a 72 percent rise). Based on these and other results, we discuss several implications for performing stress test in general, such as selecting appropriate empirical model (OLS vs. quantile regression), setting threshold for a partical risk indicator (choosing between 99th vs. 95th confidence interval), and establishing international best practices (and performing further research to that end) with regard to these and other analytical issues.

Summary

Policy Study KOR Analysis on the Korea's Economic Growth Using the General Equilibrium Mode: 1990~2010

Growth accounting has been widely used to measure the contributions of various factors to economic growth since Robert Solow in 1957. However, growth accounting fails to explain and implicate each contribution when viewing macroeconomy under general equilibrium. This study utilizes general equilibrium theory to analyze the growth of the Korean economy. The general equilibrium model holds micro- foundation such as optimizing behavior of economic agents; hence it allows studying of channels in which economic agents optimize in the economy.

The outcomes of the study include: First, in general, Korea's per capital GDP growth rate and the growth rate of total factor productivity for the past two decades showed similar trends; Second, the fall in hours worked appears to be partly attributable to the increase in the wage (income) tax, and in addition, labor market efficiency is found to be improving, since the labor market wedge, which is derived from the equilibrium labor condition, has become smaller. The policy authority should realize the impacts of taxation on the growth of production factor and its implication when making decisions on economic policies; and third, the capital-labor ratio is on the rise, which is a sign of capital deepening, and further it indicates that the economic structure of Korea is now in transition to the capital-intensive industry.

Summary

Policy Study Margin and Funding Liquidity: An Empirical Analysis on the Covered Interest Parity in Korea

During the global financial turmoil in 2007-2008, deviation from the covered interest parity (CIP) between the Korean won and US dollar through the foreign exchange swap has escalated in its magnitude beyond 1,000bp in November 2008, and it still persists around 100bp level. In this paper, we examine a newly developed margin based asset pricing model using the Kalman filter approach and show that the escalation of the CIP deviations is found to be significantly related to the global dollar funding illiquidity and country-specific funding conditions. Furthermore, we find evidence that the poor funding conditions (or higher margins) are driven by the general money market illiquidity and may lead to higher funding illiquidity, which suggests the reinforcing effects of the liquidity spiral. We also show that the supply of dollar liquidity and improved funding conditions help alleviate the deviations from the parity, however the persistent anomaly is found to be related to the high level of exchange rate volatility.

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