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Analysis of output fluctuations in Taiwan: an application of the IS-MP-AS model.

Article Excerpt
Abstract

Extending the IS-MP-AS model, this paper finds that real GDP in Taiwan is positively affected by real depreciation and stock values and negatively associated with the government deficit/GDP ratio, the U.S. federal funds rate, and the expected inflation rate. Therefore, current large and rising government deficits, recent appreciation of the New Taiwan dollar, and gradual increases in the federal funds rate would hurt real output in Taiwan. (JEL E52, E62, F41)

Introduction

This paper attempts to examine output fluctuations in Taiwan based on the extended IS-MP-AS model [Romer, 2000] and the Taylor rule [1993; 1998a; 1998b; 1999] and has several different aspects. First, the IS-MP-AS model is extended to include several additional variables such as stock prices and the exchange rate. Households are likely to increase their consumption spending when assets such as stock values go up because of the wealth effect. Business firms are expected to raise investment spending with increased stock values due to Tobin's q theory or the balance-sheet channel [Mishkin, 1995; Kuttner and Mosser, 2002]. Second, the Taylor rule [1993; 1998a; 1998b; 1999] is extended in formulating the monetary policy reaction function so that the CBC would target the interest rate based on the inflation gap, the output gap, the exchange rate gap, and the world interest rate. Third, comparative-static analysis is employed to determine the direction and magnitude of a change in one of the variables on equilibrium output.

The paper is organized in the following manner. The evolution of Taiwan's economy is presented in the second section. The empirical literature is surveyed in the third section. The theoretical literature is described in the fourth section. The model is presented in the fifth section. Empirical results are reported and analyzed in the sixth section. A summary and conclusions are made in the last section.

The Evolution of Taiwan's Economy

In recent years, Taiwan's economy experienced challenges and made progress. Its economy reached the bottom in 2001 or 2002 and then gradually climbed out of the recession. Real output declined 2.18 percent in 2001 but bounced back quickly to grow 5.71 percent in 2004. Per capita GNP decreased from US $14,188 in 2000 to US $12,798 in 2001 and then rose to $14,032 in 2004. Industrial production grew 7.4 percent in 2000, declined 7.8 percent in 2001, and then rose 9.9 percent in 2004. The unemployment rate rose from 2.99 percent in 2000 to a high of 5.17 percent in 2002 and then declined to 4.44 percent in 2004. Because unemployment went up and income declined, the growth rate of household consumption spending changed from 4.9 percent in 2000 to 1.0 percent in 2001 and then rose 3.13 percent in 2004. Sluggish businesses and lower expected profits reduced the growth in private domestic investment spending from 15.70 percent in 2000 to -29.2 percent in 2001, but it bounced back strongly to grow 28.2 percent in 2004. The deficiency in aggregate demand caused the inflation rate to change from 1.3 percent in 2000 to negative rates dung 2001-2003 and 1.6 percent in 2004.

To increase aggregate demand and employment, the authorities launched the Expansion of Employment Plan and the Infrastructure Expansion and Economic Revitalization Program creating 104,000 jobs and 100 public projects in 2003. The authorities raised spending by NT $50 billion to deal with SARS in 2003. Challenge 2008: National Development Plan was launched to raise a total of US $21 billion from the government and the private sector in order to achieve an annual growth rate of 5 percent or higher, enhance research and development, develop a knowledge-based economy, and other goals. Due to expansionary fiscal policy, the government deficit/GNP ratio rose from 1.3 percent in 2000 to 2.5 percent in 2001 and is expected to reach 3.3 percent in 2005, the deficit/government spending ratio also rose from 14.0 percent in 2001 to a projected 20.7...

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