Essays on income inequality exchange rate and policy coordination

Copyright by Xiaojun Yang 2003 The Dissertation Committee for Xiaojun Yang Certifies that this is the approved version of the following dissertation: Essays on Income Inequality, Exchange Rate, and Policy Coordination Committee: David A. Kendrick, Supervisor Li Gan Vince Geraci William Glade Hong Yan Essays on Income Inequality, Exchange Rate, and Policy Coordination by Xiaojun Yang, B. Dissertation Presented to the Faculty of the Graduate School of The University of Texas at Austin in Partial Fulfillment of the Requirements for the Degree of Doctor of Philosophy The University of Texas at Austin May 2003 UMI Number: 3116243 ________________________________________________________ UMI Microform 3116243 Copyright 2004 by ProQuest Information and Learning Company. All rights reserved.

This microform edition is protected against unauthorized copying under Title 17, United States Code. ____________________________________________________________ ProQuest Information and Learning Company 300 North Zeeb Road PO Box 1346 Ann Arbor, MI 48106-1346 Acknowledgements I am deeply indebted to my supervisor Professor David A. Kendrick for his kind guidance, advice and encouragement. Under his consistent, conscientious and patient supervision, I have gained insight about macroeconomics and computational economics, importantly how to approach academic research.

I will continue to value his friendship. I also owe thanks to the other member of the dissertation committee: Dr. Li Gan, Dr. Vince Geraci, Dr.

William Glade, Dr. Hong Yan, for their valuable discussions and suggestions, and for their generosity and kindness. Also, I would like to express my appreciation to Seung-Rae Kim and Marco Tucci for their intellectual and technical advice. Finally, I express my special thanks to my parents for their lasting support and love.

iv Essays on Income inequality, Exchange Rate, and Policy Coordination Publication No._____________ Xiaojun Yang, Ph. The University of Texas at Austin, 2003 Supervisor: David A. Kendrick The goal of this dissertation is to develop and to use computational methods to study issues in policy coordination, exchange rates and income inequality. The topic of policy formulation among interdependent economies has received much attention in the literature.

In the first essay a two-country model is used to illustrate the interdependence of China’s and Hong Kong’s economies. Not surprising, we find that the policy effect is asymmetric, due to difference in size. Shocks to the Chinese economy will affect Hong Kong’s stable economic growth. In order for Hong Kong to keep a stable growth, both governments must act in certain ways.

Particularly, by importing more China can help Hong Kong’s economy, especially during the financial crisis years. We find that fiscal policy is v more effective than monetary policy in affecting economic activities in this model. In the second essay, we develop a model to study the behavior of the Yuan/Dollar exchange rate. The parameter values estimated for the model are such that when China increases its relative money supply, the exchange rate appreciates, which is different than the conventional result.

Also the parameter values indicate that in order for China to have a higher level of GDP, China has to increase its money supply; and for a stable exchange rate, China either decreases its money supply then increases it or increases its money supply during the entire period. The right policy hinges on the desired path for the exchange rate. Since the model is simple in essence, the results should be interpreted with caution. The third essay analyses the contribution of different factors to the determination of income inequality.

The questions regarding whether greater income inequality is conducive to China's growth and the role of degree of reform for growth and inequality have been studied in the paper. We find a positive correlation between income inequality and growth, that reform plays a dominant role in determining growth and income inequality, and that steady growth can not be emphasized too much, otherwise the reform process will be reversed, which is not practical. Finally, the tradeoff between income inequality and growth is analyzed. vi Table of Contents Chapter One: Introduction.

1 Chapter Two: Economic Interaction and Policy Coordination Between China and Hong Kong .3 The Optimal Control Theory.4 The Model with Price Variables.1 The Model Equations… .5 The Model with Price Variables in the Control Theory Framework. 50 Chapter Three: Yuan - Dollar Exchange Rate Model .2 Developments of China's Foreign Exchange System.1 The Model Equations… .1 The Control Framework .2 Results and Experiments. 95 Chapter Four: Reform, Inequality, and Growth .4 Control and Sensitivity Analyses .1 The Control Framework .1 Sensitivity Analysis from 1991 to 1998 .2 Sensitivity Analysis from 1998 to 2010 .1 Caring More about Income Inequality .2 Caring More about Growth Rate .3 Greater Difficulty to Further Reform .4 Inequality verse Growth. 152 Appendix A-1 Historical Simulation.

154 Appendix A-2 Simulation Results for China's Fiscal Expansion. 158 Appendix A-3 Duali Input File 1. 162 Appendix A-4 Duali Input File 2. 179 Appendix B-1 Comparison of Different Money Supply.

198 Appendix B-2 Duali Input File. 199 Appendix C-1 Constant Inequality, Growth and Inflation. 204 Appendix C-2 Duali Input File. 206 Appendix D-1 Data-China.

212 Appendix D-2 Data-Hong Kong. 220 viii Appendix D-3 Data-US. 231 ix Chapter 1: Introduction The topic of policy formulation among interdependent economies has received much attention in the literature. China and Hong Kong are economically closely linked.

Policy initiatives in one economy may influence the evolution of economics variables in the other. In the first essay a two-country model is used to illustrate the interdependence of these two economies. Not surprisingly, we found that the policy effects are asymmetric, due to differences in size. China’s economic policies have a big effect on Hong Kong, but the reverse is not true.

However, China and Hong Kong’s economies are intertwined. A shock to the Chinese economy will affect Hong Kong’s stable economic growth. In order for Hong Kong to keep a stable growth, both governments must act in certain ways. Particularly, by importing more China can help Hong Kong’s economy, especially during financial crisis years.

In doing so, China has to have higher government expenditure and Hong Kong has to have higher money growth. At the same time, Hong Kong should steadily increase its government expenditure and China should keep a stable money growth. Fiscal policy is more effective than monetary policy in affecting economic activities in this model. In the second essay, we develop a model to study the behavior of the Yuan/Dollar exchange rate.

We connect the exchange rate with China and America’s income, money supply, interest rate, and current account. The parameter values estimated for the model are such that when China increases its 1 relative money supply, the exchange rate appreciates. Also the parameter values indicate that in order for China to have a higher level of GDP, China has to increase its money supply; and for a stable exchange rate, China can either decrease its money supply then increases it or increase its money supply during the entire period. The correct policy depends on the desired path of the exchange rate.

Since the model is simple in essence, the results should be interpreted with caution. The reform and open-door policies in China have liberated people’s work incentive and enthusiasm. Important aspects of this change are that people have more job choices and more opportunities, and that income inequality has increased. The final chapter analyses the contribution of different factors in the determination of income inequality.

The questions regarding whether income inequality is conducive to China's growth and the role of degree of reform for growth and inequality have been studied in the paper. A two-period model with two-group households—rural and urban—is introduced to illustrate factors that should be considered in income distribution and growth. Based on this framework, equations are developed for urban income inequality, rural income inequality, growth and inflation. Contradicting a popular view regarding East Asian countries, a positive correlation between income inequality and growth was found.

The other findings are that reform plays a dominant role in determining growth and income inequality, and that steady growth can not be emphasized too much, otherwise the reform process will be reversed, which is not practical. Finally, the tradeoff between income inequality and growth is analyzed. 2 Chapter 2: Economic Interaction and Policy Coordination Between China and Hong Kong 2.1 INTRODUCTION The economic reforms that took place in mainland China in the late 1970s began a new process that fundamentally changed the economic relationship between mainland China and Hong Kong. In the 1960s and 1970s, Hong Kong’s economic growth rate reached, on average, almost 10 percent per year.

However by the early 1980s high land rents and wages began to erode Hong Kong’s international competitiveness that had been the basis of its success. Coincidentally, the emergence of such pressures coincided with China’s open- door policies. Thus a mutual benefit situation arose between the two and the forging of much closer economic relations began. We want to know how the two economies interact, how policy interaction can increase their welfare, and what policy instrument is more effective in affecting the economies.

In this paper a two-country model is used to illustrate the interdependence of these two economies and also answer those questions. We found the policy effect is asymmetric, due to different size. China’s economic policies have a big effect on Hong Kong, but the reverse is not true. However, China and Hong Kong’s economies are intertwined.

The shock of the Chinese economy will affect Hong Kong’s stable economic growth. In order for Hong Kong to keep a stable growth, both governments must act in certain ways. China can help Hong Kong government reduce expenditure without hurting Hong Kong’s economic growth.coordination Fiscal policy is more effective than monetary policy in affecting economic activities. The chapter is organized as follows.

Section 2 describes the model. The optimal control theory is presented in section 3, where we describe the quadratic linear problem, give the solution process for the system, and associate the dynamic optimization method with our problem. In section 4, the price variables are added to the model to see the role of monetary policy, where we also present policy simulations. Section 5 puts the expanded model in the control theory framework and gives a sensitivity analyse.1 The Model Setup The model consists of the GDP identity and functions for each of its components.

Specifically, for the Chinese economy we have: CYt+1 = CCt+1 + CIt+1 + CGt+1 + CXt+1 – CMt+1 CCt+1 = a0 + a1CCt + a2CYt+1 + a3CYt CIt+1 = b0 + b1CIt + b2CYt+1 + b3CYt CMt+1 = c0 + c1CMt + c2CYt+1 CXt+1 = d0 + d1CXt + d2HYt+1 where CY, CC, CI, CG, CX, and CM stand for China’s GDP, consumption, investment, government expenditure, exports, and imports respectively; 4 essays.coordination For the Hong Kong economy we have: HYt+1 = HCt+1 + HIt+1 + HGt+1 + HXt+1 – HMt+1 HCt+1 = e0 + e1HCt + e2HYt+1 HIt+1 = f0 + f1HIt + f2HYt+1 + f3HYt HMt+1 = g0 + g1HYt + g2HYt+1 HXt+1 = h0 + h1CYt + h2CYt+1 where HY, HC, HI, HG, HX, and HM stand for Hong Kong’s GDP, consumption, investment, government expenditure, exports, and imports respectively. Economic theory has little to say about the lag structure, and the lag variables are included in the stochastic equations, since they result in a better fit of the model to the data. Since all the endogenous variables are interrelated between China and Hong Kong as well as within each economy, we use two-stage least squares to estimate the model. We use all the relevant variables as the instrumental variables.

When the Durbin-Watson statistic indicates a first-order serial correlation, we use the Cochrane-Orcutt technique to correct it. The following is the estimation result1: For the Chinese economy: CYt+1 = CCt+1 + CIt+1 + CGt+1 + CXt+1 – CMt+1 1 The data we used is from “Statistical Yearbook of China” from 1987 to 2001 by SSB.93 For the Hong Kong economy: HYt+1 = HCt+1 + HIt+1 + HGt+1 + HXt+1 – HMt+1 HCt+1 = -2799 + 0.