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Gauging Deflation Risk in the Korean Economy by Looking at Liquidity Preference

Gauging Deflation Risk in the Korean Economy by Looking at Liquidity Preference

KANG Min-Woo

Mar. 30, 2009

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Originally released on February 26, 2009


Falling asset values due to the global financial crisis has raised the potential for deflation. In 2008, US$7.7 billion in asset value, including real estate, stocks and bonds, evaporated in the US alone. Deterioration in asset value implies a rise in the value of currency and gives rise to falling consumer prices. In turn, deflation leads to severe sluggishness in domestic demand and, with the collapse in the value of collateral, a fall in corporate loans ? a credit crunch. Deflation is even more costly to the economy because it prolongs a recession, paralyzes the intermediary function of the financial market and is not easily fixed by governments.

Though the possibility of deflation can be gauged through demand and expenditure, it can also be gauged via liquidity preference. When times are bad with excessively sluggish domestic demand and a high degree of economic instability, businesses and individuals exhibit increased propensity to stockpile cash (i.e. liquidity preference). Under these circumstances, even a huge liquidity injection by the government or the central bank, may lose its effectiveness as a large portion is simply hoarded. This exacerbates sluggishness in domestic demand, and consumer prices fall further, eventually pushing the economy into deflation. Since the financial crisis started to intensify in September 2008, liquidity preference has strengthened in the US as well as in Japan. In the US, in particular, cash holding propensity derived from the money multiplier equation almost doubled from 0.108 to 0.199 in four months. This suggests that a prolonged decline in asset value and economic decline increase the likelihood of a liqu idity trap or deflation.

In the case of Korea, the propensity to retain cash was low at 0.003 as of December 2008, half the level of long-term average propensity since the 1997 currency crisis. Core inflation also remains high, above 5%. Moreover, estimating the money demand function indicates that rate cuts are still effective in stimulating the economy. Considering these factors, it seems premature to worry if the Korean economy is heading toward a liquidity trap or deflation. However, the government needs to devise appropriate policy responses as the Korean economy has already entered in recession with falling asset values. Expanding liquidity supply is still a valid option to ease tight credit. In addition, an increase and swift execution of government spending, and deregulation to prevent asset prices from a hard landing will be needed.

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