Monetary policy regime change and regional inflation dynamics: looking through the lens of sector‐level data for Korea

• Published date: 01 December 2017
• Author: Róisín O'Sullivan,Joo Yong Lee,Chi‐Young Choi
• Date: 01 December 2017
• DOI: http://doi.org/10.1111/1468-0106.12121

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MONETARY POLICY REGIME CHANGE AND REGIONAL

INFLATION DYNAMICS: LOOKING THROUGH THE

LENS OF SECTOR-LEVEL DATA FOR KOREA

CHI-YOUNG CHOI*University of Texas at Arlington

JOO YONG LEE The Bank of Korea

RÓISÍN O’SULLIVAN Smith College

Abstract. This paper explores the impact of the adoption of inflation targeting (IT) on the dynamics

of city-level inflation in Korea using both aggregate and sector-level data. When looking at aggre-

gate regional inflation, we find that the mean, volatility and persistence fell in all cities in the wake

of the monetary policy regime change, consistent with other evidence in the literature. Delving more

deeply into the disaggregate data reveals additional insights however. For most of the changes we

observe in the dynamics of regional inflation, we find that the aggregate effects are being driven

primarily by sectors that fall into the ‘Services’ category. We posit that the impact of better anchored

inflationary expectations is primarily on the less-traded services sectors of the economy, where the

domestic monetary policy framework has a relatively larger influence. When it comes to the

increased co-movement observed across regions under an IT regime, however, it is the ‘Commod-

ities’ sectors rather than ‘Services’ that are responsible, probably because services inflation becomes

relatively more influenced by local factors once it has stabilized within the target range. Therefore,

adoption of IT may not necessarily increase all measures of regional synchronization even when the

goal of better-anchored inflationary expectations is achieved.

1. INTRODUCTION

There is a large literature examining the impact of inflation targeting (IT) on

inflation performance at the aggregate level (e.g. Mishkin and Schmidt-Hebbel,

2007; Choi et al., 2011). The basic result in the empirical literature is that the

adoption of IT is typically followed by a fall in both the level and volatility of

macroeconomic measures of inflation such as the CPI, especially in emerging

economies. Moreover, a fall in inflation persistence has often been noticed in IT

countries, probably due to better-anchored inflationary expectations after an

explicit announcement of an inflation target in the medium term. There is ample

empirical evidence, however, of a significant degree of heterogeneity in the

inflation dynamics of different economic sectors and different geographic

regions (e.g. Bils and Klenow, 2004; Beck et al., 2009). In fact, researchers

looking at the impact of monetary policy actions have found substantially

different responses to a common monetary policy across regions, with these

differences often associated with regional differences in sectoral composition

*Address for Correspondence: Economics, University of Texas at Arlington, 701 S. West St, UTA –

Economics, Arlington, Texas 76019, USA. E-mail: cychoi@uta.edu.

The authors are very grateful to Nelson Mark (co-editor) and an anonymous referee for constructive

comments and suggestions that helped improve the paper. The views and analysis expressed in this

paper are those of the authors, and do not necessarily represent the views of the Bank of Korea or

Bank of Korea policy. Any remaining errors are the authors’.

Pacific Economic Review, ••: •• (2015)

doi: 10.1111/1468-0106.12121

© 2015 Wiley Publishing Asia Pty Ltd

Pacific Economic Review

, 22: 5 (2017) pp. 814–840

doi: 10.1111/1468-0106.12121

© 2016 John Wiley & Sons Australia, Ltd

(e.g. Carlino and DeFina, 1998). Furthermore, recent studies using sectoral data

have documented heterogeneous effects of a switch in monetary policy regime

on the dynamics of disaggregate inflation (e.g. Choi and O’Sullivan, 2013). In

light of the possible interface between sectoral and regional effects, it would be

instructive to examine the impact of a change in the monetary policy regime

using data disaggregated along both these dimensions in identifying the chan-

nels through which the adoption of IT might influence the macroeconomy.

Given that large and persistent differences in regional inflation dynamics pose

challenges for a one-size-fits-all monetary policy, it is important for policy-

makers to understand what drives inflation differentials across various regions

within a nation. Because these differences may stem from diversity in sectoral

composition or the segmentation of labour and product markets, examining the

heterogeneity of regional inflation data at the sectoral level seems promising in

terms of providing useful policy implications.

The main objective of this study is to explore the responses of disaggregate

regional and sectoral inflation measures to a change in monetary policy regime.

Our analysis aims to provide evidence on: (i) the disparity in the regional-level

response to a change in the national monetary policy regime and the impact on

regional inflation co-movement; and (ii) the role of differences in sector-specific

responses. This evidence can potentially provide additional insights into possible

consequences of changing a country’s monetary policy framework. To this end,

we study the case of Korea with its official adoption of IT in 1998.1

As an emerging market economy, Korea is an interesting country to study,

especially given its degree of openness and its potential role as a case study for

other Asian economies considering the adoption of IT or that recently adopted

IT (such as India). Moreover, the availability of city-level inflation data for

various sectors over a reasonably long time span permits a rich analysis of the

issues at hand, including the analysis of regional responses across various

sectors. Although this is not the first study of the impact of IT adoption on

Korea, we are not aware of another study that looks simultaneously at the

variation across sectors and regions of the impact of the monetary regime

change.2Kim and Park (2006) provide an excellent general overview of the effect

of IT adoption on Korea, but they use aggregate headline inflation only.

Tillmann (2013) studies extensively the impact of IT adoption at the regional

level in Korea, but focuses on the response of inflation persistence at the aggre-

gate level without considering sectoral-level developments. In general, these

studies conclude that IT was successful in stabilizing inflation in Korea, but not

much is known about the extent to which this stabilization was felt broadly at a

1Korea formally adopted inflation targeting in late 1997 when the Bank of Korea (BOK) law was

revised to explicitly announce a target rate of inflation from April 1998 (see Kim and Park, 2006).

At the outset, the country followed a version of IT known as flexible inflation targeting, with M3 still

being used as an intermediate target, prior to becoming a ‘full-fledged’ inflation targeter in 2001.

Given that the impact on inflationary expectation formation is most likely to have occurred from the

outset, we use April 1998 as the formal adoption date for our analysis.

2A similar line of research looking at both regional and sectoral disaggregation has been conducted

in a cross-national context among EU countries (e.g. Lunnemann and Matha, 2004), which differs

from our focus on intra-national analysis.

C-Y. CHOI ET AL.

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© 2015 Wiley Publishing Asia Pty Ltd

© 2016 John Wiley & Sons Australia, Ltd

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