THE ROLE OF THE CENTRAL BANK AND
ENFLATHON EN KOREA, (945.1960

Thesis {or the Degree of DH. D.
MECHEGAN STATE UNEVERS'ETY
Nae Hoon Chang
1962

THESIS

This is to certify that the

thesis entitled

The Role of the Central Bank and

Inflation in Korea, lQHS-l960

presented by

Nae Hoon Chung

has been accepted towards fulfillment
of the requirements for

Economics

 

_Ph_:_’l°___ degree in

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THE ROLE OF THE CENTRAL BANK MD IM-‘LATION
IN KOREA, 1945-1960

By

NAEHOONCI'MKS

A THESIS

Submitted to
lflchigen Stete University
in partial fulfill-ant of the requirements
for the degree of

DGJTOR 0F PHILOEDPHY

Department of Be enemies
1962

For thii “”d'
my: 0f I! dug”
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ACWLEDGENTS

For this study I an grateful to Professor John )4. Hunter, the
chairman of fly dissertation conittee. His burden has been heavy. He
not only guided the preparation of my thesis but was kind enough to
edit the draft. lithout his considerate help, this dissertation would
probably have never reached its final form. My appreciation is very
deep.

It is a pleasure to express my gratitude to the nenbers of my
dissertation conittees Professors Abba Lerner, Leonard Rail and
Victor Suith. The lost constructive and careful cements made by
Professor Lerner helped us to iaprove any parts of fly dissertation.
I an especially grateful to Professor Smith for his genuine interest
in my work. His penetrating and painstaking guidance has been very
helpful to so. I would like to thank Professor Rall for his many
helpful suggestions and constant encouragement.

I an also grateful to all the lowers of the noney workshop
at Iichigan State University. Particularly, I would like to express
.y appreciation to lillian Breit, Stanley Groves and Robert Haney
Scott for their genuine interest and support. Professors Tho-as
hyor, Boris Pesek, Andrew Briner and Iichael DePrano have given no
invaluable guidances during the workshop sessions.

Professor Paul Strassnan kindly read the first four chapters
of .y thesis. His advice helped no to avoid a miner of errors. I

an also indebted to Professors Carl Brehn, Subbiah Kannapan, Anthony

11

Lac Im' lx G. mailer

For counting
:eteived priceless tss
1cm. Dorothy Alden

final draft of this (1‘.

 

iii
Koo and In: G. mailer.
For counting statistics and typing the original draft, I
received priceless assistance frost lies Irene Takasiya. Many thanks

to Ira. Dorothy Alden for her patience and promtness in typing the
final draft of this dissertation.

N. H. Chung

lLllJldglms e e e
Limih'olea . . .
list of Illustrations
faster
I. mmrcx
II. RECENT 82th
General Re;
C'Pitalisaa
Divided In
The Period
III. mecm IN‘

Introducti.

Wins: In
Financm

 

TABLE OF CONTENTS

Page

ACkflOIICdg-Ont' e s e e e e e e e s e e e e e e e e e e e e 11

List Of TabIC' e e e e e e e e e e e e e e e e e s e e e e V11

Li’t Of Illu.tr.t1°n. O O O O O O O O O O O O O O O O O O 0 1X

Chapter
I.

II.

III.

IV.

V.

InmION C O O C O O C O O O O O O O O O O O O 1
REEF! EONNIC DEVELOPENI' OF KOREA . . . . . . . 5

General Remarks

Capitaliss in Korea

Divided and War Economy

The Period of Recovery and Reconstruction

FINAEIALIISIITUTIONS.............. 21

Introduction

Banking Institutions Before 1945

Financial Institutions After the Liberation
Banking Refor-

Inforlll Financial Institutions

THEEJOPEOFUNETARYPOLICY........... 45

Introduction

The Uses of Funds and Iaplications for
Ionetary Policy

Open-hrket Operations

Discount Rate Policy

Reserve Require-ants Policy

Sources of Funds and Additional Issalications
for Ionetary Policy

mmmmnYOOOOOOOOOOOOOOOOO 72

Definition of loney Supply
The Honey Supply
Seasonal Behavior of the loney Supply
The Post-liberation Period
The Korean War Period
The Currency Reform and the Period of
Tight Honey Policies

iv

TA

31:19!
11, THE [VETEPC
1945 - I9t

The Prat-1e

The Averaq

The Icveme
Period c
The Cver
The Pcst
The Kore
The Peri
A Brief

III. WTICR’SIIIF
EIICKIC C

Introducti
Korean Eco
Sose Struc
Structure
111011511:

 

 

TABLE OF CONTENTS - Continued

Chapter Page
v1. nus aovsaerrr or me name LEVEL,
1945 " 1960 e e e e e e e e e e e e e e e e e e 113

The Probleu of the Price Index
The Average Denomination of Currency
The flovenent of Price Level
Period of Currency Reform
The Over-all Period
The Post-liberation Period
The Korean War Period
The Period After Currency Reforu
A Brief Su-ary

VII. BEATIONSHIP BETWEEN IONEIARY POLICY AND
mmm DEVELOPBNT O C O O O O O O O O O O O O 158

Introduction

Korean Economy and Inflation

Sous Structural Problems
Structural Unenrloynent
Inelasticity of Supply
Price Structure

The Role of Monetary Policy and Economic
Reconstruction

Theoretical Ground for the Optima Pattern
of Ioney Supply

The Estimation of the Optima Pattern of
Honey Supply

Ionetary lanagewent Experienced in Korea
Policies for Credit Control
Loan Ceiling Policies
An Appraisal

VIII. WWADGDDCLUSION.............. 200

Sumary
Conclusion and Recomndations

BIBLImRAPHY O O O O O O O O O O O O O O O O O O O O O O O 217

”PawnOOOOOOOOOOOOOOOOOOOOOOOOOO II
Chapter A. The Index of Average Denomination of
the Currency
Chapter B. Comarison of Indices
Regression Analysis
An Alternative Comarison of Indices
The Behavior of Velocity
Chapter C. Index of Real Output
Chapter D. Note on Relationship Between Real Output
and the finder of Notes

 

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1945 . 1960

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Table
l .A

1.8
LC
2.

3.

4.

5.
6.

7.

9.

10.

11.

12.

13.

14.

LIST OF TABLES

Percentage Distribution of liner-ale and
lineral Resources before 1945. . . . .

Electrical Generating Capacity .

Iwumial ”duetime e e e e e e e e e

State-ants of Conditions of All
C~r¢1.lB.nk.eeeeeeeeeee

Interest and Discount Rates of
m1mrya.&.000000000000

Interest and Discount Rates of the
mnkfixor..eeeeeeeeeeeee

Balance Sheets of the Bank of Korea. . .
Percentages of Loans sade by Banks . . .

Seasonal Index of honey Supply and
DC‘w DCPO’it v.1001tYe s e e e e e e

Factors Affecting Money Supply . . . . .
Note Issues, Government Overdrafts, and
Advances to 0.11. Forces, June, 1950 -
P.hfl't7g1%1eeeeeeeeeeee

Comarison of 1952 Executed Budget and
1953M90teeeeeeeeeeeeee

Connecting the New Denomination to the
OIdDCHMMtioneeeeeeseeee

Percentage Distribution of Denomination
Before and After Currency Refor- . . .

Index of Average Denomination, the Seoul
lholesale Price, and Ioney Supply,
19‘s-].96ooeeeeeeeeeeeee

Break-down of Price, 1945 - 1960 . . . .

vi

Page

12
12
12

47

59

60
67

69

102

110

134

135

139
150

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The Result of

Indices of Rea

LIST OF TABLES - Continued
Table Page
15. Year-to-Year Changes in Prices, Optim-
Rates of busy supply and Excessive
R.t.. Of IDRCY SUPPIYe e e e e e e e e e e e e e e 181
16. Year-to-Year Change in Ioney Supply, (hatin-
Ioney Supply, and Ioney Supply Attributed
to the Public and Private Sectors. . . . . . . . . 188
A. The Index of Average Denomination. . . . . . . . . . II
B. The Result of Regression Analysis. . . . . . . . . . IX

Ce IndicC3 Of R981 OUtPUt e e e e e e e e e e eee e e e XXIV

vii

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1. Iain of Averfi
Seoul lholes

A. Changes in Ion
Deposit Velo

 

LIST OF ILLUSTRATIONS

Chart Page
1. Index of Average Denomination, the

Seoul lholesale Price and Honey
Slipply, 1945-60e (1947 I 1m)e e e e e e e e e e e 142

A. Changes in Honey Supply and Denand
Deposit Velocity, 1952-60. . . . . . . . . . . . . 15A

viii

I.

 

 

THE ROLE OF THE CENTRAL BANK AND INFLATION

IN KOREA, 191. 5—1960

By
NAE HOON CHUNG

AN ABSTRACT OF A THESIS

Submitted to
Michigan State University
in partial fulfillment of the requirements
for the degree of

DOCTOR OF PHILOSOPHY

Department of Economics

1962

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ABSTRACT

The purpose of this study is to investigate the problem.of
inflation in Korea with particular emphasis on the role of the Bank
of Korea. Since persistent inflation is not possible without a
continuous increase in the money supply, the role of the Bank of
Korea has been important. The problem of inflation has attracted
a great deal of attention in Korea, yet no systematic study has
been made. This study, though exploratory in nature, aims at a
systematic inquiry as to whether or not the Bank of Korea achieved
the goals of monetary policy: Maintaining price stability and
inducing economic growth.

As a criterion for judging the performance of the Bank of
Korea, the Optimum.pattern of the money supply is estimated for
the last fifteen years on the following theoretical basis: When

the Fisherian equation is expressed in a differential form, we

Bet ELM}! +97! :- 9152 +5131 ...(l), T being the real national

income. When prices are stable, dP is zero; therefore, the apt-
imum increase in the money supply (1.6., not contributing to

inflation) is L111) '= g__'_r_ _ (1.1]. ...(2). When dP is not zero,
M T V
the actual increage in the money supply would be M = Li .-
M T
g_E’ + d P ...(3). By substituting equation (2) into (3), we

P
cessive increase in the money supply will be reflected directly

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in an increase in general prices. The elimination of this amount

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Abstract

Nae Hoon Chung
of the excessive money from the actual money SUpply will be an
Optimum.increase in the money supply.

In caution, it must be mentioned that the Optimal increase
in money supply in this study is meant only to provide an approx-
imate criterion in evaluating the performance of the Bank of Korea.
The estimation of the Optimal increase in the money supply is based
on the actual behavior of velocity on the assumption that the
difference in policy of the central bank would have no effect on
the behavior of velocity. Though statistical evidence shows no
dependent relationship between changes in the money supply and
changes in velocity, the interpretation of the Optimal increase
in money supply is adjusted for possible changes in velocity.

The limitation of the formula above is the fact that it

is based on a differential formula. Therefore, a modified formula,

491
4 M = 1 “ W "' 1 , is used in the estimation of the
M 0 +42

P

optimal increase in the money supply.
is price indices available in Korea are unreliable, an index
_of the average denomination of currency is computed. Comparison
of indices indicates that the index of average denomination is
preferable to the index of the Seoul wholesale prices for the
purpose of this study. Although the theoretical formulation of
the index of the average denomination is based on certain restricted
assumptions, the index provides challenging insights in.understanding
the true movement of the price level.
The money supply since 1945 has been far greater than the

Optimum.pattern of the money supply. Moreover, credit expansion

 

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Abstract Nae Hoon Chung

attributed to the public sector alone has been greater than the
optimum.pattern during the period under study. This indicates
that government deficits have been the major cause of inflation
in Korea.

When bank credit to the public sector was greater than the
safe rate of increase in money supply, the Bank should have attempted
not only to prevent the subsequent credit expansion by requiring
lUO per cent reserve requirements, but also should have contracted
the equivalent amounts of credit in the private sector. There
was no such attempt on the part of the Bank. Attempts only to
restrain the credit expansion were made, yet the attempts were
very ineffective. This strongly indicates that the Bank of Korea
failed in achieving the goals of monetary policy.

One of the reasons for the failure of the Bank has been the
government dominance in the banking system. The establishment of
the Monetary Board was expected to bring a sharp break from conven-
tional banking practices. However, the Board became an appendage
of the Ministry of Finance in practice. Because of political pres—
sures, commercial banks often made loans without any form of col-
lateral, wnich consequently develOped into delinquent loans.

The sc0pe of monetary management is extremely limited in Korea.
Due to the absence of money markets, traditional tools of monetary
management are totally, or at least partially ineffective. Con-
sequently, selective tools of control were heavily relied upon.

The circumstances were not entirely propitious for reliance on

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Abstract Nae Hoon Chung

selective controls and, furthermore, their application was less
than vigorous. At the beginning, the attempts were sporadic. Some-
what more systematic control measures were later develOped.

The institutional arrangement seems to be very important.
The reform equipped the Bank with wide and flexible discretionary
powers and all available tools of credit control. This necessarily
resulted in complications and confusion in monetary management.
Furthermore, the conflicting uses of a variety of tools nullified
the potential effects.

The conclusion of this study is that the Bank of Korea
failed in achieving the goals of monetary policy and the conclusion
lends supports of the ”stability—first" argument. It also leads
to a recommendation for a reserve requirements policy as high as
100 per cent for reasons of effectiveness and simplicity. Open-
market Operations can be used in expanding the money supply in

order to foster the growth of money markets.

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CHAPTEII

INTRGJLCTION

Since the birth of the Republic of Korea. inflation has been a
constant and persistent ailment of the Korean economy. Since persistent
inflation is not possible without a continuous increase in the money
supply, the role of the Bank of Korea, the central bank, has been impor-
tant. The purpose of this study is to investigate the problem of infla-
tion with particular emphasis on the role of the Bank of Korea from 1945
to 1960. To be specific, this stuiy purports to inquire whether or not
the Bank of Korea succeeded in achieving the goals of monetary policy.
This inquiry is imortant because the Bank of Korea was established in
1950 in an environment in which stepping inflation was the utmost goal
of the national economic policy.

In regard to policies. there has been controversy about “recon-
struction before stability" and “monetary stability'before reconstruction".
Yet. national policies, with few exceptions, supposedly have intended to
stop inflation. From one regime to another, however, policies failed to
reach their goals until the recent Military Revolution of 1961, mich
seems determined to achieve stability and economic growth at the same
time. Though this study is not concerned with this controversy. findings
of this study may provide an answer to this controversy.

In view of the scope of the problem. this study is necessarily a
general type of inquiry. In particular, the expl'ératory nature of this
study. rather than its problem solving nature, should be emphasized at

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2

Ihen one studies economic problems of an underdeveloped country,
the first thing to deal with is the problem of measurements. without
some sort of accurate measurements, precise reckoning is not possible.
For this reason, some are inclined to say that use of theory for economic
development is not feasible. Such is the case in Korea. Though data on
the money supply are considered to be somewhat more reliable than other
data available, there are no reliable data for national income, pro-:-
duction, population and prices. The data for the money supply published
by the Bank of Korea, with some adjustments, are used in this study.
The index of the average denomination of cm-rency is constructed for
use as a price indeau The index of prices so comuted and the data for
the money supply are key items on which this study is based.

Other data used in this study are either provided by government
publications or comuted by crude methods, as deemed necessary. In
order to prove certain points, it was necessary to use an indirect
method rather than the direct method. For example, in proving the
relative constancy of velocity behavior, the behavior of the demand
deposit velocity is used as an indirect method of, gauging the behavior
of velocity of money. These are the reasons why the emploratory nature
of this study should be stressed.

Inasmuch as the problem is broad in this study. the focus of
the study is based on a few crucial factors. For examle, it is assmed
implicitly that the study of inflation can be made, without much dis-
tci-tion, through the study of the behavior of the money supply.

Since the behavior of the money supply depends upon institu-

 

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3
tional arrangements, economic environment and the mentalities of men
who operate the institutions, in Chapters II and III an eephasis is
put on elaboration of the institutional and historical factors. The
scope of monetary management is analyzed in Chapter IV. In this chapter,
an effort is made to evaluate the efficacy of the conventional tools of
central banking in the particular environment of the South Korean economy.
A brief, yet careful, description of the new model of central banking
designed by Professor Arthur Bloomfield is made.

The behavior of the money supply is analyzed in Chapter V.

A very rough comarison of the behavior of the aggregate money supply
before and after the establishment of the Bank of Korea, seasonal beha-
vior of the money supply and the behavior of the money supply for several
periods are included in this chapter. The focus of the chapter is in
investigating factors underlying the money supply.

In Chapter VI a theoretical analysis of the index of the average
denomination of currency is made. The study of the movements of price
level is based on this index of the average denomination in comarison
with the Seoul wholesale price index.

In Chapter VII the relationship of monetary policy and economic
development is presented in the context of the findings analyzed in
previous chapters. In particular, this study attempts to estimate the
optimal increase in the money supply. The optimal increase in money
supply is defined as an increase in money supply that will not affect
the price level in any way. In caution, it should be mentioned that no
determination of the optimal increase in money supply can be made in a
precise fashion. The optimal increase in money supply in this study is
meant only to provide an approximate criterion in evaluat ing the per-

4W

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man of the Bank or
am He basis of
1m, possible changes

33W VII.

 

Tho balance of
M9"! attention, 4

W WW it hand

 

4

formance of the Bank of Korea during the last fifteen years.

On the basis of judgment about the performance of the Bank of
Korea, possible changes in the use of monetary tools are recomnded
in Chapter VII.

The balance of payments and the exchange rate problem, worthy
of greater attention, are considered only incidentally as they relate
to the subject at hand.

-fl
a—V'

:' General Reaar‘u

South Korea
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CHAPTER II

RECENT ECONOMIC DEVELOPMENT OF KmEA

W
South Korea is in an intermediate stage of economic develOp-

ment. More than fifty per cent of the population is making a living in
agriculture, though a fair degree of light industry has developed.
According to the 1959 national income statistics at 1955 prices,
agriculture, forestry and fishery account for 38.8 per cent of the
national income; manufacturing, 13.8 per cent; wholesale and retail
trades, 15.1 per cent; construction 4.7 per cent; public utilities,
conunication and transportation, 4.5 per cent; insurance and real estate,
l5.l per cent; the rest of the world, 1.1 per cent; and government ser-
vices, 4.5 per cent. Other‘types of services constitute the remainder
of the economic activities.1
In this chapter a historical review of Korean economic develop-
ment will be presented. In particular, eaphasis is put on expomding
the genesis of economic growth and the conflicting problems in the process
of economic development in the last fifteen years. Economic development
is closely related to political development in any country. In fact, the
economic development of Korea is largely the by-product of political
developunt. Politically, Korea is a most unfortunate country. On the

eve of awakening from a long and self-contained dream of Confucianism,

the Korean economy found itself in the midst of an international

1Bank of Korea, 13 Econmgs-Ssatistigs Am :1, 1961 ed.
(Seoul: Bank of Korea, 1961), p. ll.

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6
struggle for power. For almost forty years Korea was under Japanese
control. After the defeat of Japan, Korea was divided into North Korea
and South Korea as the consequence of the cold war between the lest and
East. Korea seems to be learning a new way of life the hard way and at
the greatest expense.

The Co-unist invasion in 1950 brought the virtual collapse
of the South Korean economy, which was then almost ready for a positive
step of economic reorientation and reconstruction. Active combat. below
the 38th Parallel ended very early in 1951, yet the Korean economy
of South Korea was able to begin functioning again, though very slowly
for some time and at an increasing rate later. By the end of the l953-54
fiscal year, the total output of goods and services reached roughly
the level of the last fiscal year before the war.

Since the war, aid from various countries, especially the United
States, has been a crucial factor in the survival of the South Korean
economy. In the matter of policies for economic reconstruction, a
close cooperation betnen the United States and the Republic of Korea
was launched early in 1954. The rate of recovery, however, has been
rather slow; the average rate of economic growth was little more than
4 per cent per annu. Thus, by 1960 the national income wasabout. 25
or 30 per cent above that of 1953.2

g, Qapiflligm in Kgreg ,
Until the Kwanhwa-do Treaty was first signed with Japan in

 

’ 2there are no available data on either national income or
production for the period earlier than 1953. Only rough indices of
goods and services are presented in Chapter C, Appendix.

“1

and 11*“ 'i‘b '
Erase: [am I“ the
£33315 mp, prina!
-. tufts. Korea In
safficimtnviono 7
£thle UH l '
manic north. The
waisted throughout

nighysical phases 0
*‘e reunion of Kor:
h‘i‘u‘ioml environ:
39111! Itintaimd an:
Ell‘lill 111581; 0‘ ion

"“1; Personal ties.

 

7
1876 and later with the United States, China, Germany, Russia and
France, Korea was the ”Hermit Kingdom.“ The village was the basic
economic unit, primarily dependent upon agriculture and small-scale
handcrafts. Korea was a stable, orderly and economically self-
sufficient nation. The feudalistic society lacked the dynamics
of technology and a middle class and in turn, social changes and
economic growth. The so-called "Asiatic stagnation” of feudalism
persisted throughout the centuries with little change in the social
' and physical phases of life. Perhaps the most important reason for
the stagnation of Korean economy in that period was the peculiar
institutional environment in which a Confucian bureaucracy was
rigidly maintained and in which a highly stratified aristocratic
political institution bound men to the land through strong feudal-
istic personal ties.

After the Kwanhwa-do Treaty, the Hermit Kingdom became a
pair in the power politics of capitalism in the Far East. Rivalry
for the control of Korea led to the Sino-Japanese lar of 1894-1895
and the Russo-Japanese lar of 1904-1905. Japan soon emerged
victorious from both wars, established a protectorate over Korea in
1905 and forcefully annexed Korea to Japanese capitalism in 1910.

After 1905 there was a wide-scale infiltration of Japanese
influence in politics and economics. In 1912 the Japanese governor-
general promulgated a series of laws. The most important one was
“The Real Estate Certificate Ordinance," which established private
1"“ oewiership. This ordinance made the Japanese governor-general

the 18139.31: land-owner in Korea. The land was later sold to

.‘cnese ciranies at
he of cost. The 31;
.1535 of the cumnc
11:: built I fine new
' spun.

Un‘il 1930 the
n‘i-irdustrhlizat ior
mailing in mile:
W in 01‘5” to “pp:
a timed "Sour: e 5
J: sag q.’ K0“. 1

3W9 '0: 1d 1

"Plum,

3' rapid
tiring [and '31 I. h

fusion of Hindu“, 1a

0
an.

.H in

th func‘ion

-__——

 

 

8
Japanese companies at a low price or distributed to Japanese imigrants
free of cost. The Japanese governor-general implemented a series of
reforms of the currency, taxation, budget and others. The Japanese
also built a fine network of railways, roads and other comunication
systems.
Until 1930 the design of the Japanese policies was strictly

anti-industrialization3

, the classical example of colonial policies
prevailing in earlier days. The Japanese policies were to exploit the
land in order to supply food for the Japanese empire and to extract
the mineral resources for the growth of Japanese manufacturing. At
the sue time, Korea served as a market for Japanese industries.
During Iorld Iar I the Japanese economyrexperienced a great
expansion. The rapidly expanded industries on the Japanese mainland
during lorld lar I, however,_faced a precipitous crisis after the
3 war. This crisis led to a stronger grip on Korea and led to the
invasion of flanchuria in 1931. The invasion of Manchuria made the
Korean economy a bridge between Japan and Manchuria. This basic
shift in the function of the Korean economy was accompanied by the
gradual inflow4 of the Japanese capital into Korea so that Japan

could economize locational advantage and minimize transportation

3» to the Japanese policies in Korea, there is much liter-

ature. See: Jerome B. Cohen, Japan's Econoy in War and Reggn-
gtrmtion (Minneapolis, University of Minnesota Press, 1949),

pp. 33-47. See also: *6. C. Allen, Japanese Industry: It; Recent

Develognt g msgnt Condition (New York: Institute of Pacific
Press, 1940)

4Japanese net investment in Korea totaled about $800 U.S.
million for the years 1937 through 1944 according to the estimate of

net trade balance. See: UNKRA, An Econgig Progggg for Keg-gag Re-
consfimtion (Prepared by Robert R. Nathan Associates, Inc., New York:
195‘ g 9.24.

M. 5, m time .3
may hd btcom co:
ms.

men Japan Ia
mistrial mitt and 1
'zm‘s of 11.5. illitar'
fined to the Korean t
‘5‘“ MIN“ Ian

InPakistan, ;
Eirdus after the part
mural mor‘mity
mm by ‘59 J Jpn

W rich q. n" .n

12".: ”“5.

thus, m. Nat

 

 

9
costs. By the time Japan was involved in Norld Nar II, the Korean
economy had become completely integrated into the Japanese economic
nexus.

than Japan was defeated in 1945, about 2,400 business and
industrial units and more than 160,000 residences passed into the
hands of 0.3. Military Government in Korea, and were later trans-
ferred to the Korean government as vested properties. Host of the
vested properties were sold to the public by the Korean government.

In Pakistan, business enterprises abandoned by fleeing
Nindus after the partition of India and Pakistan provided entre-
prenueral opportunity to Pakistanese.5 The business properties
abandoned by the Japanese, likewise, were an inportant foundation
upon which the nee entreprenuerial experience in Korea took place
after 1945.

Thus, the Nathan Report, states that Korea has probably
enjoyed more industrial develOpment than any of its neighbours in
the Far East with the exception of Japan.6

The assessment of economic development of Korea under
Japanese control is controversial. Some Jestern economists and

Japanese7 argue to the credit of Japan, while Koreans unanimously

 

1l’l-lenry G. Aubrey, “Industrial Investment Decisions“: A Com-

parative Analysis”, lggnal of Eggnggg History, XV, No.4, December,
1955, p. 349.

MA, Ops Cife’ p. 36o
7UNKRA, 1229.0: p. 25, also John P. Lewis, Recongtructigg

g! Develomnt in $233!; Kgrea (National Planning Association
Publication: Planning Puphlets No.94: lashington, D.C., 1955), p. 9.

3m thi‘ proposlt ior
m Korean ugmn‘
11;» than economic f

mispmnt n: clearl-

—— -_ ' ___ _-5

 

3‘1: Mud of none:
June» occtpation.
37‘“ “PM“ [as 99
mm (‘ ‘hf conse
WWW n: unbal
rm 8 to economic
It also shoul:
m‘ly m m, CWpua‘L
[stem tmnpnmurs

Imugh ski“ W 1hr
sq

m. “man, of

 

 

10

decry this proposition and argue against the Japanese occupation.8
In the Korean argunent, perhaps, the non-economic factors have a greater
weight than economic factors. The fact remains that the genesis of
development was clearly rooted in the soil of Korea and the capital-
istic method of economic growth in Korea was implemented by the
Japanese occupation. It is also true that the development of Korea

by the Japanese was geared to the requirements of the Japanese

economy. As the consequence of this policy, the pattern of economic
development was unbalanced and crippled when the Korean economy was
viewed as an economic entity.

It also should be mentioned that entrepreneurs in Korea
today are not cemarable to those of the western countries. The
western entrepreneurs climbed up from the middle class positions
through thrift and innovating actions, while those in Korea are
mostly the remants of the feudal elite aided and abetted by the
modern government. To this extent, they lack the dynamic necessary
for economic growth.

LEW

lhen the United States Army occupied South Korea in September
1945, South Korea was in a chastic situation. The economy was run
dam, not only because of the Japanese exploitation, but also because
of repatriation of the Japanese and the division of the peninsula

into South and North. I

8Kwan Sook Park, "Some Criticisms on Japanese Claims for
Properties in South Korea'f, Korean; ngterly, III, No. 1 (Seoul:
Ste-er, 1961), pp. 42-51., “so see: Moon Hwan Choi, ”The Path to
Democracy", aid" pp. 52-70.

m widen 59;
my W : chao‘
riaaof Japan!“ 1“
niwiuwon mi 3“
oases of supply Ier
3d predation decli
3' clinical fortilize
1d supplies doquate
:1:in hm lif‘lng
Imminlly, by the
Lterminal pmonml x
FWEImm, tho Japa
mm. the the re;
M‘ indie: post

“mp: the
'i 9’" into South
Woo.» into . p

If 11b“; ion, hi

 

11

The sudden segregation of Korea from the Japanese economic orbit
brought about a chaotic situation in production and trade. The repatri-
ation of Japanese left the country with broken-dam machinery without
administrators and skilled technicians. Traditional market channels and
sources of supply were cut off completely or disorganized thoroughly.
Food production declined sharply largely because of the unavailability
of chemical fertilizers. Korea, a former eXporter of rice, no longer
had supplies adequate even to meet the domestic needs. ”Thus, benefits
derived from lifting the yoke of Japanese control were more than offset
economically, by the departure of a large portion of 'the managerial and
technical personnel responsible for the operation of the Korean economy.
Furthermore, the Japanese took some ships and possibly other movable
assets. Also the repatriation of many Korean citizens from Japan added
to the i-ediate post-war problem of readjustment."9

Perhaps the greatest blow to the Korean economy was the division
of Korea into South and North, which left little hope for South Korea's
development into a prospering self-sufficient economic entity.10 The
distribution of industrial resources and industrial production, before

11 North

the liberation, between North and South is shoen by Table 1.
Korea is primarily an industrial zone, while South Korea is predomi-

nantly an agricultural area with a modest amount of light industry.

 

9mm“, 22. 911', Pe 37a

10The importance of unification and need for continued aid to
reconstruct. industries in Korea were stressed in the report submitted
in April, 1948, by the Johnston Connittee, which was composed of
Percy l-l. Johnston, Paul G. Hoffman, Sidney H. Scheuer, and Robert F.
Loree. See: Kyung Cho Chung, W (New York: Nacuillan
Co., 1956). p. 101s

“in. Bank of Korea, W No. 68, 92, cit" p. 11.

‘ q n!- I” w
. - mh Dam .:
_ l I I |

Goh
' .v -- . ‘ ' ' * ” ‘ GoldandSilve
' _‘ honihe
.' -. .' . ._'- ‘g _ f ‘ a - ' Refined Iron

. tungsten
I y. . . .7 . Graphite
’ , Coal
5151‘s;-
I
' 1
South 1
North 1
I I I
- IN;

 

[a
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H-
0.
e0

 

I.

 

12
TABLE 1 ’ A.

PERCENT AGE DISTR IBUIION OF SOME MINERALS MD MINERAL PRCDLCTS
(1945)

South Korea North Korea

Gold 29.5 70.7
Gold and Silver Mines 27.3 72.5
Iron Ore 0.1 99.9
Refined Iron = - 100.0
Tungsten 21.5 78.5
Graphit‘ 29 e O 7 1 e 0
Coal 2.5 97.7
TABLE 1, B.

ELECTRICAL GENERATING capacm (1945)

i L! ' 3r cent
South Korea 79,500 8
North Korea 909,200 92
TABLE 1, C.
INDUSTRIAL PRGDLETION, (PER CENT)
(1945)
South Korea North Korea

Metal Products (Light) 73.0 27.0
Nachinery Products (Light) 69.4 30.6
ChCMC‘l PIOdUCT" 14e3 85e7
Textiles 76.8 23.2
F0“. 60s? 39e3
Gas 29.7 70.3
Miscellaneous 63.8 36.1

The complementary relationship between the North and South was
cut off cowletely and opposite ”isms” were implemented ruthlessly in
each region. Neither the North or the South has been able to utilize

the country's resources to a maximun degree. Furthermore, even the

airing facilities
amuse of this 9n
:‘electrici‘y, 15311
345, *h! North cont
., _ , a .. stile, but in Save
3‘51 i‘ '35 shut Of
. . .7 ' 11"?!5011‘11 Ere vi;
reigned to I few hm
- : Relrive she:
Maiden are incre
.- - A ‘ 5’“ ‘59 Nash.

.

. ; ' .I‘ is Pal“ icu
half of sh.
. reszrces +0
\ ' is ‘1‘)! tha; .
{“11 9M: Y,

..........

 

13
existing facilities of production were on the verge of extinction
because of this structural separation. For example, the major portion
of electricity, about 92 per cent, came from the North. After August,
1945, the North continued to furnish the South with electric power for
a while, but in November, 1947, that supply was cut in half. In May,
1948, it was shut off completely. Nith a lack of power, most industries
in the South were virtually idle for a period and households were
rationed to a few hours of electricity at night.

Relative shortages of consumers' goods due to the decline of
production were increased by the inflow of about 2 million refugees
from the North.

‘Contrary to such pessimism, a very Optimistic view~was expressed
by Professor John P. Lewis:

It is particularly important to realize that the southern

half of the peninsula does have sufficient human and natural

resources to support a very heavy productive expansion. It

is true that the whole peninsula, with the North's richer

fuel, energy, and forest resources and its sparser native

population, would be capable of greater development than the

South is separately. But it is not true, as President Rhee

sometimes likes to suggest for bargaining purpose, that

partition left South Korea wdth a complex of resources in
which it somehow is constitutionally incapable of being
developed to a level of respectable self-support.12

At any rate, the need for structural reorientation in South
Korea was, indeed, urgent and imperative. ‘During the military govern-
ment administration lines of policy as to how to deal with North Korea
and South Korea were confused. Naturally, the primary purpose of the

military government was to keep or establish political order. Although

 

12John P. Lewis, cg, cit., p. 22.

“”193“ ”PM“ ‘
;£.1illion I!“ We
.135, lumps if '33
automation in ‘1"

1:13:15 ms put on ‘
smiles mi fertili:
m‘tgic iniuvries
In mulled in or:
Xfichlly, slaborah
3mm, mm price

$946. Vested preps:
WI! sold at M.
‘h' Putter, 0f fa

"f Wl‘iwed lard
mu 1“}3

14

statistical reports show considerable variation, approximately $400
0.3. million were spent during the period of the military administra-
tion. Perhaps it was iapossible or premature to attempt a vigorous
reorientation in the South Korean economy. At any rate, primary
esphasis was put on the relief work of importing food grains, medical
supplies and fertilizers. A limited mount of repair work on some
strategic industries was made. Also, two floating Army power units
were installed in order to increase the deficient supply of electricity.
Officially, elaborate price control devices were eliminated in 1945.
However, some price control on essential comadities was restored in
1946. Vested properties, owed by Japanese previously, were subse-
quently sold at. auction. During the period of the military government,
the percentage of farm tenancy declined from 73 per cent to 40 per cent
of cultivated land. This was largely due to the sale of former Japanese-
ewned land.13 At the same time the growing desire on the part. of absentee
Korean lamilerds to sell out their holdings grew because of declining
returns and political sentiment in favor of land redistribution. Also,
the improved economic status of tenant farmers made it possible for them
to purchase some holdings. A major factor contributing to the improved
status of the tenant farmers was a nearly 50 per cent reduction in max-
imum farm rents decreed by the military government shortly after the
liberation“

On August 15, 1948, the Republic of Korea was established, and

 

——_—— —

1'3A‘1rthur I. Bloomfield and John P. Jensen, W
W (New York: Federal Reserve Bank of New York, Narch,
1951), P0 150

a, minim» 1V1
Tried States Ill;
a1 1%. In the I
2151: km mliei
119mm 10, 1‘.
111' *1: [arm gm
#99, control *h
mitotic rm of
‘1“ Wided for
5111 of Chosen, tn
tit: ‘ht Korean g¢
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fm' “eh m pp
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‘i‘ion.

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be

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“to th U

 

05- am.
ho hum)
1:301»);me J

15
the administrative control was almost completely transferred from the
United States Nilitery Government to the Republic of Korea by the end
of 1948. In the meantime Anrican economic aid policy shifted its em-
phasis from relief to economic rehabilitation by signing an agreement
on December 10, 1948. Based on the Economic Cooperation Agency (ECA)
aid the Korean government agreed, among other things to balance its
budget, control the amount of money and credit, and to establish a
realistic rate of foreign exchange as soon as possible. The agreement
also provided for the establishment of a ”counterpart fund" in the
Bank of Chosen, the central bank before banking reform of 1950, into
which the Korean government was to deposit the won equivalent of all
0.8. aid made available to South Korea.

lith the establishnIIt of the Republic of Korea there emerged
a clear sign of political stability. Economically, however, some
discouraging sign appeared as the tempo of inflation started to pick
up. The Korea government now set up and financed a sizeable military
force, wish was previously paid out of 0.8. Army appropriations.

The government also attenuated an ambitious plan of economic rehabili-
tation. .

The rising spiral of inflation brought critical attention from
the public and the 0.8. aid authorities. Largely by the persuasion
of the latter, the Korean government initiated the Fifteen Points of
Stabilization Programs, which basically reinforced the 1948 agreement
between the 11.5. and the Republic of Korea.

The interwar period was one of most significant, progress for
the South Korean economy. The 0.8. contribution of approximately

(J; 30 . “1110“. I

 

bed to whim Si
1:11.101?” "‘ "i
:n‘ by 1950 mm,

m m comm”
call mi “mic M
57"!!! b99mm Of

ful sins 0‘ "mil

Efforts f0:

 

mom MA. I
imshn of 4. NW
*mi‘cry of South '
first m: of var.

umimm mach
an": the 11391"
n: gum: in pron
Tm national econou
u I newcomer.

WM. ”I due

1952-

99
53 prices.
text of

P.

16
$100 0.8. million, which was managed very efficiently through the E.C.A.,
helped to achieve significant progress in over-all industrial production.
Grain output was raised by more than 25 per cent and the industrial out.-
put by 1950 seemed, over all, to have increased by more than one-half
above its disorganized period of liberation. Strategic supplies lihe
coal and electric power increased several times above the level of 1945.
, By the beginning of 1950, consequently, the Korean economy showed hope-
ful signs of rehabilitation and economic reconstruction.

Efforts for economic stabilization and reconstruction on the
part. of the E.C.A. and the Republic of Korea turned into ashes after the
invasion of the North Korean columnists of June, 1950. Much of the
territory of South Korea was fought over two or three times during the
first year of war. Production, trade, transportation, communication,
administrative machinery were all disrupted. Physical damages far
greater than imagined resulted from the war. “The war damage in Korea
was greater in proportion than in any other country in modern history.
The national economy today may be likened to a flower garden in the wake
of a steamroller. Little is left but the root."14 According to a 0.11.
source, the damage mounted to something above $1.8 0.8. billion at
1952-53 prices. Roughly 43 per cent of industrial facilities, 41 per
cent of power facilities, and over 50 per cent of mines were reported
to be daaged besides housing, public buildings, ships and others. The

Office of Public Information of the Korean government, on the other

 

14[(yung Cho Chung, 22, cit"

mi, aloud estiaates
nthowh the dam
mono“ estimate, a
*h lonan economy.
l. ’31, Period of Reccw
Post-war Korea
goods, especially of c.
molacemnt of capii a]
59‘ also because of (i
no “I!!! or not a
this so that tin gm
The United
ities ‘hmugh its
5°” h‘i “his “.3.
la: .N'lem

and
“cmttmqon b

In 1950
ek “his“ “3‘ i
“the 8'31th

17
band, released estimates of war damage amounting to $3 billion. 15

Although the damage resulting from the war defies a reliable
quantitative estimate, available information suggests a vital blow to
the Korean economy.

4. The Period of Recovery and Reconstruction

Post-war Korea was caught in a tight shortage of all kinds of
goods, especially of capital goods. This was due not only to the little
replacement of capital under Japanese control and during the Korean lar,

but also because of damage from the war. A crucial question, therefore,
' was whether or not a sizable and timely transfusion of capital was avail-
able so that the South Korean economy could heal the scars of the war.

The United States was undertaking wade-scale assistance activ-
ities through its Army co-aand. The transfusion of goods was largely
done by this U.S. aid. From the war until 1952, however, economic aid
was expedient and a piece-meal type of patching operation rather than
reconstruction work followed.

In 1950 vixen General MacArthur gained the prospect of victory,
the United Nations established the U.N. Commission on the Unification
and Rehabilitation of Korea as a small policy-advising body and later
the United Nation Korean Rehabilitation Agency (UNKRA), a full-time
program and administrating organization. In the meantime the Korean
government also worked out a detailed, somewhat over-ambitious plan
of reconstruction in 1951.

Despite its early start reconstruction planning remained slow,
uncertain and hesitant. By the end of 1952 no unified plan for recon-

struction was formed.

 

158ml: of Korea, Monthly Bulletin No. 66, (April, 1954), p. 13.

A: tho prospect

 

inphoo'mg for monstn
om nhuod Bubm‘s
grit of tho reconstruct
fibril, 1953. Upon t
Eisenhowr nqmstod
lpprooriatioo of $200
Korean nlhf and "my
*‘ ‘1! me tin:
KW in order to “cm
“mm" The most 1;
RM?» 1953. which

“333“ m Mm. thq

18

As the prospect of a truce became brighter, increased activity
in planning for reconstruction was apparent. In December, 1952, the
UNKRA released Nathan's Report, the first comprehensive general blue-
print of the reconstruction program. The Iasca16 mission visited Korea
in April, 1953. Upon the submission of the Tasca report, President
Eisenhower requested and the U.S. Congress granted an emergency
appropriation of $200 million as the first installment of South
Korean relief and rehabilitation.

At the same time there was a series of reforms on the part of
Korea in order to accomplish a comprehensive over-haul of the economic
structure. The most important among them was the currency reform of
February, 1953, which aimed to absorb the excess liquidity in the
economy and reduce the size of denominations of outstanding currency.

The truce agreement at Panmunjum was signed after severe con-
flicts between President Rhee and the U.S. Department of State. The
government as well as civilians returned to Seoul after the truce
agreement. The Combined Economic Board (CEB) was established with
a joint memberships of the United States and the Republic of Korea.
Aid agencies,‘with the exception of UNKRA, were put under the
direction of the C.E.B. The C.E.B. has been the main body of
economic programming and policy-advising.

The new departure for reconstruction, however, was sadly
disappointing. In the Fall of 1953 overt conflict between the

United States and the Korean government concerning the general

 

16This was a special U.S. Presidential economic mission under
the leadership of Henry J. Tasca.

manic ”my beam
m mention of ”'0
issu '15 ”Wed at *
in: 60 M to 180 hwar
fimcial stabili‘Y “d
gable; has been one of
in Korean economy. '3‘!“
Segotiations broke dew
in November, 1954.13
The basis of
shculd precede econo:
WOT‘ 0i Ithe monet

”‘1‘ m in favor o:

19

economic policy became evident. The rest of the year was devoted to
the negotiation of the new official hwan-dollar exchange rate. This
issue was settled at the end of 1953 by increasing the exchange rate
from 60 hwan to 180 hwan"L7 per dollar with an agreement about
financial stability and economic reconstruction. The exchange rate
problem has been one of the most serious issues in economic policy
in Korean economy. The issue was reopened in the middle of 1954.
Negotiations broke down once again until a new agreement was reached
in November, 1954.18

The basis of the conflict was whether or not monetary stability
should precede economic reconstruction. The United States was in
support of the monetary stability argument while the Korean govern-

ment was in favor of the reconstruction-first argument.19

 

fi—

. ~Hwan is an accounting unit of Korean currency, which is
equivalent to 100 won in old currency before the currency reform of
February, 1953.

18A rate of exchange applicable to the advances to the U.N.
military authorities was raised to 500 hwan per U.S. dollar. In August,
1955, the official rate of exchange was raised to 500 hwan per U.S.
dollar, which replaced the multiple rates of exchange existing
previously. ' , '

19The monetary stability argunent might have appeared to the
Korean government to be the acceptance of permanent stagnation of the
wartorn economy of South Korea, in view of the fact that American aid
didn't appear to be sufficient to the need of the Korean economy as
is indicated by John J. Lewis:

1. Despite the |'bold approach" of 1953, 0.8. policy still reflects a
basic conflict between the sire of Korea's minimun aid requirements
for successful reconstruction and lashington's diminishing tolerance
for foreign assistance spending.

2. Partly because of budgetary austerity, we persist in trying to buy
two things - extraordinary R.O.K. military strength, and economic
reconstruction - for little more than price of one in Korea.

3. Reconstruction progress is still harried by inadequate joint plan-
ning and a record of inept inter-governmental relations.

Cf! Jam Fe “'1‘, 02: Cite. pp. ‘1'46e

In general, ‘1
hesitant in 1951 and '
mile of 1954. A sy
golizy 'oetseen the Ur
melon effort bacl
lasting.

From 1955 or
cur-all 3709?“ of
and use: of funds ,,
BY 195‘ L"i‘Jfi‘l‘ial

lb 5“ tin ‘h‘!

2D

In general, the enthusiastic beginning of reconstruction was
hesitant in 1951 and 1952 and practically collapsed in 1953 until the
middle of 1954. A systematic plan of recovery, coordination of
policy between the United States and Korea and an aggressive recon-
struction effort backed by a bold investment of economic aid was
lacking.

From 1955 on, however, the situation gradually improved. The
over-all programtof economic reconstruction and the plan for sources
and uses of funds were under the guidance and control of the C.E.B.
By 1954 industrial production showed a significant improvement. At
the same time the Korean government enforced an austerity policy in
fiscal and monetary spheres especially after the exchange rate depre-
ciation in August, 1955. After 1958 the economic aid declined to a
noticeable degree and severely restricted the Korean government's

fiscal operation.

1. Introduction

At the presem
Mom (central ban]
martial banks. The
ionic: cities of ‘1‘“
baking system is ratl

In addition, 4
162 brmch offices am

much offices of the

till reopens 1W3, an

\

, . Ofe
Q (1954 5’” "°

~ 'hic
‘39 Offic ,
mitiamie‘ 1‘ USQ'd a

. Dug.

CHAPTER III

FINANCIAL INSTITUTIONS

1, Introduction
At the present the Korean banking system consists of the Bank

of Korea (central bank), the Korean.Reconstruction Bank, and four
commercial banks. These banks maintain more than 300 branch banks
in major cities of the country. Considering the Korean economy, the
banking system is rather well developed, in fact, over developed}

In addition, there is the Agricultural Bank, which maintains
162 branch offices and 388 sub-branch offices. These branch and sub-
branch offices of the Agricultural Bank, which used to be the finan-
cial seeperatives, are located in major cities and rural areas and serve

development projects of industries, commerce, fishery and agriculture,

 

1Professor Koh Seung Jae quotes S. G. Panadikar's Banking in
India (1954), in which the ratio of population to the number of bank-
ing offices is used as the index of degree of development of banking
institutions. According to his method, population per bank office
is as follows:'

U.S...........3,056 I"d1.eeeeeeeee387,000
U.K...........4,816 KOT.’eeeeeeees111,063
J‘pCDeeeeeeeee9’496

This index can be used as a rough index at the risk of serious
logical defects. However, this index does not tell if the banking
institutions are adequate to a particular economy. In the case of
Korea, banking institutions served not only the Korean economy, but
also for Manchuria, China, and the Japanese mainland to some extent.
After the separation of Korea from the Japanese economic orbit,
naturally some excess banking facilities were left idle. Evidence
to support this hypothesis is the fact that in 1954, about 28 branch
offices were closed. Many branch offices continue to operate at a
less. See Jae Jegng (Seoul: Jae Jeung Sa, April, 1955), pp. 50-85.

21

.........

.........

...........

 

as also engage in orer
pawl mlng system is
daily lies to tap the
Th0 existence c
We of inclement, t
corporate stocks are t
call-loan sarket or at
HOD-existent in the ‘l

"n 1" some of ch.

Ill‘hts,

It! fomtio
1% technic‘l m ‘1.
335%. m, “er 1

K.-
o'em tun”. c

on at. “$13 of "<
‘Qhrl P0 I‘men Of
mm“ "Name

My. ”Pm-1am

'6‘. s

22
and also engage in ordinary banking business. The network of the
postal saving system is scattered all over the country, and essen-
tially aims to tap the small sotn-ces of savings.

The existence of capital markets is still in the infant
stage of development, though some government security and a few
corporate stocks are traded in an unorganized ”entity market. The
call-loan market or other short-term money markets are virtually
non-existent in the accepted sense of the terms. Most of the short-
term and some of the intermediate loans are financed through informal
markets.

The formation of the present day Korean banking system, in
its technical and structural framework, was taken after the Japanese
system. The year 1950 is called the "era of banking reform in South
Korea.” A series of banking reform measures were carried out largely
on the'basis of recouaendations made by Arthur I. Bloomfield and
John P. Jensen of the Federal Reserve Bank of New York. Yet, the
over-all structure of the banking system in South Korea did not
change appreciably by these reform measures, except the adoption
of the central banking system, which was patterned to a large
extent after the Federal Reserve system of the United States. The
establishment of the central bank in Korea, although it is somewhat
belated, was an act of conformity with the general tendency of the
revival of monetary policy after 1945.

2, “53mg Etitutigng Befm 1%

A. The Bank of Chosen

The development of the central banking system dates back to

1373 inn *1! Dlilchi
fa purpose of the Pu
*9 W1: trade bet-e
in exchange business.

In the midst
Sign, been a finan
Korean Gmmw in
allowd the Dailchi B
”thanking tystem, _
*‘m bmk functioned a;
“Max:152 0n the 1
WW ‘0 I‘llblish a
mum",

In 1909 *he D.

m“ °f ”1' Bank of

9: *1“ DiiiChi B‘nk b1

3939991“ cm".

than: th. .m

u
mm, mm in

hfla¢1°n.'3
Y an a:

23

1878 vixen the Daiichi Bank of Japan set up, a branch office in Pusan.
The purpose of the Pusan branch office of the Daiichi Bank of Japan was
to smooth trade between Korea and Japan by providing loans and engaging
in exchange business.

In the midst of a political tangle, Mr. Toshitaro Megata, of
Japan, became a financial advisor to the Ministry of Finance of the
Korean Goverment in 1905. The vulnerable Korean financial situation
allowed the Daiichi Bank of Japan to infiltrate into the Korean govern-
ment, banking system, industries, and agriculture. From 1883 to 1909
the bank functioned as the fiscal and note-issuing agency of the Korean

Government.2

0n the part of the Korean indigenous bankers, there was an
attemt to establish a central bank in 1899, but their plans did not.
materialize.

In 1909 the Daiichi branch office in Seoul became the head
office of the Bank of Korea, a central bank, and the branch offices
of the Daiichi Bank became the branch offices of the Bank of Korea in
respective cities.

Toward the end of the Ti Dynasty, the last dynasty in Korea,
the banking system in Korea faced a crisis, the so-called "nickel

inflation."3 By an arrangement made by Megata, a loan agreement was

 

ahis seemed to happen together with a series of reform
measures; tax reform, currency reform, etc., which were advised

by mgata. See: Bank of Chosen, Egmfic History of Chosen (Seoul:
Bank of Chosen, 1921), pp. 37-42, til-57, and 58-71. -

arwo types‘of coins, nickel and copper, were circulating in
Korea as the median of exchange. The Korean government over-issmd nickel
coins (16 different kinds), and an enormous amount of counterfeits were
prevailing until hundreds of different kinds of coins were in circulation.
Cf: Bank of Chosen, mid” p. 49.

jj v ;"

m. h...” the K
we: diich the De;
mam-y ard acted
zillion yen of the
In 1911 the
in: ass mile: the <
Ifu: tte enactment
Apart from t
um, ‘11: Bank of C.
functions, “my, In

in; m‘fiwons, am

'3“ 71' Bank also
‘3 fang";

 

24
made between the Korean government and the Daiichi Bank of Japan,
under which the Daiichi Bank of Japan controlled the Korean National

Treasury and acted as a central bank in 1909 in return for three

million yen of the loan.4

In 1911 the Bank of Korea was named the Bank of Chosen. The
Bank was under the complete control of the government, especially
after the enactment of the National General Mobilization Law.

Apart from the privilege of issuing legal tender currency in
Korea, the Bank of Chosen performed other traditional central banking
functions, nmaely, holding reserves and rediscounting for other bank-
ing institutions, and acting as banker and fiscal agent for the govern-

ment. The Bank also conducted the ordinary banking and trust business

as follows :5

a.l)iscounting bills of exchange and other commercial paper;

b. flaking loans on reliable security and granting advances;

c. flaking loans without security to public bodies;

d. Purchasing government bonds, bonds issued by prefectures
and municipalities and other negotiable securities;

e. Engaging in foreign exchange business and purchasing and
selling gold and silver;

f. Receiving deposits and providing safe custody for precious
metals (gold, silver, etc.), and documents;

9. Conducting trust business;

h. Acting as agent for other banks and collecting bills for
companies and merchants maintaining regular business
relations with its offices;

i. Engaging in any other business as ordered by the government.

~ ‘Seung Je Koh, “The Development of the Modern Banking System in
Korea," Korean; Quarterly II, No. 4 (Seoul; Spring, 1960), p. 87. The
Daiichi Bank also undertook the currency readjustment business which was
to substitute the Korean coins for new coins of the Bank of Chosen.

5U.S. Department of Army, Sect on 3; lane B n
(Civil Affairs Handbook, Army Service Forces Manual, M 345-5;
Iashington, D.C., November, 1944), p. 41.

1.1!

O—v

rte Bank of C
m denlopmnt bank I
*o *‘m private sector.
*he gommnt. Conse
by the utter degree
he annexation of Kort
4: mm of pay-mm
‘ionary ”0"“? p0111
reline t1. am of ‘1
I'MJC'Pi‘Il m dis
litbout mun-mg ,,
with “up ”NY pol
W

1:01le the

3 I.
('1! Of lean in 1878
Wiflly,

25

The Bank of Chosen was the largest commercial bank and the larg-
est development bank making 1ong-term loans to the government as well as
to the private sector. In fact, the Bank of Chosen was the appendage of
the goverrnent. Consequently, the policy of the Bank was characterized
by the extreme degree of expansionism of that period. For example, after
the annexation of Korea to Japan, the Bank faced a constantdeficit in
the balance of payments. The Bank, however, did not conduct a contrac-
tionary monetary policy. ”A raising of the bank rate was sure to
relieve the Bank of this difficulty by calling home Ehe Japanese main-
landjcapital and discouraging imports. ...But this could not be done
without interfering with the industrial progress then going on, for
which cheap money policy was most necessary."6
WM

Fellowing the establishment of the Pusan branch of the Daiichi
Bank of Japan in 1878,-infiltration of other Japanese banks occurred
rapidly. The infiltration of Japanese banks in Korea necessarily spurred
the growth of Korean-owned banks,'such as the Chunil Bank (1896), the
Ransung Bank (1900), and the Ranil Bank (1906).7 After the establishment

of the Bank of Chosen, the Japanese held a complete grip over the Korean

 

6Bank of Chosen, 22, 911., p. 204.

7Most Korean-owned banks except the Hanil Bank suffered from
insufficient capital for their operations. The Governor-General of Korea
issued a decree which was to increase the bank's capital. The Kanjo
Kyodo Storage Company, set up in 1905, and the ‘Kanjo Tegata Guild, set
up in 1904, supplied loans to the Korean-owned banks, and eventually exer-
cised an 1.11» authority over the management of banks. The Korean-
owned banks were soon subject to approval by the Governor-General of
Korea of the bank's operating function, appointment of executives and
distribution of dividends.

0"

.....

U '
Q
t s I
C A
I
2
I
k , U
-l
'I'I
I
l r “ r!
‘0 -'I
F '_ -
x "
cl
'
(0 .-.‘
\ u
m u‘
”l "
7 I.
I I i
’ ‘-

t)

financial system. It
era .14; Japanese b
3mm Gummy *OOk

Chosen Courcial Ban
Kama. In the aidd 1e

hm mm six comer

Korea.

II'Jum, 1906
"‘Ihlishing micult
Ci‘hzofxmh To

a total of 50 prov inc

1933. Thu cooperat iv

26
financial system. , The Korean banks with meager capital were forced to .
merge with Japanese banks or companies. For example, the Kanjo Kyodo
Storage Colmany took over the Chunil Bank in 1912, and started the
Chosen Co-ercial Bank, which is the most important conercial bank in
Korea. In the middle of 1940 it had 44 branches and agencies in Korea.
There were six comercial banks with 115 branches in major cities of

Korea.
§s__la§!airial_§enka.

In June, 1906, the Korean government put into force a decree
establishing agricultural and industrial banks in six major provincial
cities of Korea. To supplement the agricultural and industrial banks,
a total of 50 provincial financial cooperatives were established in
1908. The cooperatives were to contribute toward ems-thing the turn-
over of farming funds and help facilitate agricultural development.
(The umber of these cooperatives increased to 338 in 1919 and 729 in
1929.)

In 1918 the agricultural and industrial banks, which were
established in six major cities, were unified as the Chosen Industrial
Bank. At the same time, 58 branch offices in Korea and two in Japan
were established. The Chosen Industrial Bank was primarily concerned
with a long-term development of agriculture, industry, mining and
fisheries, with close cooperation of the Toys Development Comany,
set up in 1908, and various cooperatives in local regions.

In the meantime the provincial financial cooperatives were

started as new financial cooperatives with the set-up of a head

affine, th' 50‘1“”
financial Cooprati
an mi more prosp
ad has been playing
fisheries and small-
D, Saving! Estitut

lell-organi:
'3 “”10?“ in Kc
founded as I subsidi

In 1931 ...m

27
office, the Federation of Financial Cooperatives, located in Seoul.
Financial Cooperatives, since its establishment in 1908, has become
more and more prosperous through several changes in its structure
and has been playing an important role in Korean agriculture,
fisheries and small-scale manufacturing.
D in s it ons

lell-crganized networks for tapping savings from the public
were developed in Korea. In 1929 the Chosen Savings Bank was
founded as a subsidiary of the Industrial Bank.

In 1931 twenty-one trust ccmanies existed in Korea} (only
five were registered and permitted to continue their business). In
1932 the Governor-General of Chosen promoted the founding of the
Chosen Trust Company, which in 1933 merged with three of the five
trust comanies and in 1934 purchased the remaining two. Later
this was called the Chosen Trust Bank. The Banks had few branch
offices in major cities. At the end-of 1938 eighteen Mutual Aid
companies were established, which later became a single Mutual Aid
Bank.

~ Finally, another mutant savings institution is the
postal savings system which was set up in 1875, being modeled after
the British and Belgian systems. After the amexation of Korea the
postal savings system was introduced in Korea. It maintained more
than 1,000 branch offices throughout the country. The purpose of

the postal savings system was to tap the small sources of savings.

in ill InS‘i‘U‘i
After the libs:

mk'mg systea remained
Fmign Exchange Bank I
may Govern-m and
All brunch: of the J a;
5m: me all owed e1
“‘3‘“ 5110:1108 of fo

banking ”3‘“: Th! non

””me credit,

Korean bulking ”Venue

 

28
in i 1 Ins ions Aft the r ion

After the liberation the structure and pattern of the Korean
banking system remained as it was before, except that the Korean
Foreign Exchange Bank was established under the United States
Military Government and that the names of various banks were changed.
All branches of the Japanese banks were closed. Thus the existing
banks were all owned either by the Korean Government or by Koreans.
[hen the branches of foreign banks are important to a country's
banking system, the monetary authority has only indirect control
over money and credit. However, this weakness did not exist in the
Korean banking system.8

The sulden separation of Korea from Japan brought about a
severe dislocation and rapid change in the structure of the Korean
banking system. For example, the existing banking system was loaded
with uncollectible assets and invalid liabilities on +11. eve of the
liberation because over half of the investments and loans of the
banking institutions were securities of and loans to the Japanese
government, Japanese companies and individuals. The bisection of
Korea also brought about a similar problem.

The basis for the establishment of banking institutions is

the existence of economic activities. The decline of economic

 

BAndrCI BrinIaer, "Banking and Finance in the Suian," in
theSggth African Jgggngl of Economics, XXVIII, No. 1 (Sudan:
larch, 1960), pp. 24-25. He states, ”the cc.rcia1 banking
system in the Sudan is similar in many respects to that in other
underdeveloped countries. For example, all banks are branches
of foreign institutions over which there is only moderate and
indirect control.”

vivid.“ dm 10 sh
[clean .CODOIY Bade ‘
ficiitiout “Mme
wusirlal Bmk wa‘ ‘
39—?er M?”‘1 ‘0
:91: funds aquired 1
with “pedal” ‘1
Men. M” the ;
‘m lending- there:
Industrial Bank. d9?
baking Operationso
the loss of 1
various banking 1115‘?
continuous inf lat

ion

despeciilizaticn cf 4

With
ions
e 7}! IX
1
”were loan
Petition

ct
. ions of m.
39:31, 5
1°“ *° fillies
3‘ +
«51” ar
an 9M t
‘hs lcs
Mn93 Bank

29
activities due to the dislocation and structural change of the
Korean economy made the Korean financial institutions a somewhat
fictitious structure. For examle, before the liberation the
Industrial Bank was engaged primarily in lending intermediate and
long-term capital to industries, agriculture, compares and fisheries
with funds acquired from the sales of debentures in the Japanese
market, especially the Do-Yo Development Company. After the liber-
ation, however, the Industrial Bank lost the funds needed for long-
term lending. Therefore, practically all banks, including the
Industrial Bank, depended on the central bank for loans for their
banking operations.

The loss of funds for banking Operations, the access of
various banking institutions to advances from the central bank and
continuous inflation after the liberation brought about the
despecialization of the banking institutions in Korea. During the
Japanese occupation the Korean banking system had developed a
fairly high degree of specialization of banking and financial
institutions. The Industrial Bank, primarily engaged in medium
and long-term loans, was also conducting a regular comercial banking
operation. The long-term lending operations were greatly reduced
after the liberation and the scape of the coamercial banking
operations increased relatively and absolutely. The specialised
functions of the Trust Bank, the Mutual Aid and the Savings Bank
declined to almost an insignificant degree because of continued
inflation and the loss of funds. Shortly after the liberation,
the Savings Bank, the Trust Bank, and the Mutual Bank requested

a fl. penlt‘td to el
to their other fmct ior‘

Thus Blood is ‘

   
 
 
 
  
 
  
 
  

All the existi
nantly in a rer
thich we have g
day of an exce -
relative to t
P“ cont reduc
1947, ”in 5s
comtry really

30
and were permitted to engage in comercial banking in addition
to their other functions.
Thus Bloomfield aixi Jensen state:
All the existing banking institutions are engaging predomi-
nantly in a regular calmercial banking business....Evidence
which we have gathered points to the existence in Korea tc~
day of an excess of ordinary ccnaeercial banking facilities
relative to the country's present needs. Despite the 25
per cent reduction in the number of bank branches in July,
1947, there still appears to be more branches than the
country really needs.9
In addition, the Korean banking system was operating on the
basis of cubersome and outmoded rules and regulations which reflected
the economic climate which prevailed under the Japanese control, and
which were not, longer at all pertinent to the Korean situation.10
After the liberation the Korean Government took possession of
vast vested properties. The controlling shares of all Korean banking
institutions, except the Financial Associations and the Chcheung
Bank, passed directly and indirectly into the hands of the Government.
This brought serious concern regarding the effectiveness of monetary
policy. Because the government held the controlling shares of the
banking system, the banking system, in fact, was the appendage of
the Hinistry of Finance. Lack of an independent banking system in
Korea naturally created the limitation of credit control; that is,
it was impossible to enforce credit control independent from

political pressures.

 

9Arthur I. Bloomfield and John P. Jensen, Banking Reform in
W (New York: Federal Reserve Bank of New York, March, 1951)
p. 63 M p. “e

10
1239.0 9 PO 3-

 

Banking 1‘1
banking institut ic
enviromnt in whi
of economic policy
Scuth Korean barki
efficiency in its
mich ass a signif
institutions befcrq
v" n“ GCOnomic e:
in ‘3' Position of
tinder tr. dmc‘ior

0f Evibu‘hlng ‘1“

31
4 R e or New Central ank

Banking reform was necessary in many aspects of the Korean
banking institutions. In particular, reform was undertaken in the
environmnt. in which stepping inflation was the most important goal
of economic policy. It was urgent to reorient and strengthen the
South Korean banking system as a whole and to promote greater
efficiency in its function. The specialization of banking functions,
which was a significant characteristic of the Korean financial
institutions before the liberation, had to be restored in the light of
the new economic environment. Therefore, the central bank was placed
in the position of leadership of reorganizing the banking system
under the direction of the Monetary Board as stipulated by the Act
of Establishing tn. Bank of Icon. and the General Banking Act.

The budget deficit has been the major cause of the Korean
inflation since 1945. The Government had to rely exclusively on
borrowing on overdraft from the central bank in order to finance
its deficit. The fact that the Government and its agencies have
been the chief borrowers from the banking system has also weakened
the ability of the Bank to control credit adequately. Important provi-
sions in the Act, therefore, are those relating to advances and
- loans to government and government agencies.

The provision about theth and maturity of advances that
the central bank can make to the government is liberal in Korea. The
Act“ provided that there is no limitation on the amount of advances

which the bank could make to the government or to the length of time

Es ish of Ko a Article 83.

int such advances wi.‘
that We fiancee out:
if indebtedmss mich
gown-at free other
Until 1955 tbs
Gonzmnt Agencies.1
not to exceed one “a
”Chm"? 'Ql‘lcultur
‘1” ‘° ”1' Public.
w "Wing One-ha]

m NE“ 0“ 511. m

m‘horim by *M N“

32
that such advances will be outstanding. The only restriction was
that the advances outstanding at any time must not exceed the amount
of indebtedness which, in conjunction with any borrowings by the
government from other sauces, has been duly authorized.

Until 1955 the central bank had also made large loans to
Government Agencies. 12 loans to Government Agencies were for periods
not to exceed one year, if the loans were for purposes other than
purchasing agricultural and other products for sale and distribu-
tion to the public. They might be renewed only once and for a period
not exceeding one-half of the original period. No formal limitations
were placed on the mounts of these loans, but such loans had to be
authorised by the National Assembly and guaranteed by the government
as to payment of principal and interest-.13 In the General Banking
Act, it was provided that all loans to Government Agencies by other
banking institutions must likewise be guaranteed by the National
Assembly.“

The most important objective of the Act of the Bank of Korea
was to convert the central bank, at that time the Bank of Chosen,
into a genuine central bank. As was described, the Bank of Chosen
conducted the business of the comercial bank, the trustkbank and

even the development bank. The Bank also performed the traditional

12Goverment Agencies comprise all ”judicial persons designated
by the Government to execute, on its behalf, projects or functions of a
public character in the fields of production, purchase, sale or distri-
bution.” The Government Agencies were abolished in 1955.

13;bid., Article so, 87 and as.

1W Articl- 23-

finc‘ions of ‘h
any significant

mud? in the if

s‘ahilitz.

Lug'lY:
been due
apprecia
a contrc
authorit
lilitary
Republic
In indept

Th! cost
‘h' Gs‘lblishmnl
Nosed of , M
£93, Tl! kt st
‘h' 9mm direc

33
functions of the central bank. It had, however, never performed to
any significant degree the role of controlling the money supply and
credit in the interest of achieving and maintaining'mnetarx

stability

Largely, the failure of the Bank to carry out this role had
been due to a lack of apprOpriate control powers, an adequate
appreciation of its special functions and responsibilities as
a controller of credit, and a chronic subservience to other
authorities, the Japanese Government, the United States
Military Government, or the Ministry of Finance of the
Republic of Korea, which have prevented it from pursuing

. an independent credit control of its own. 5

-

The most important change in the Korean banking system was
the establishment of a monetary board. The flonetary Board is
composed of a seven-men group of representatives of different inter-
ests. The Act stipulates that the Bank of Korea shall function under
the general direction of the Monetary Board and the Board shell "for-
mulate monetary, credit, and exchange policies and shall be respons-
ible for the general.direction and supervision of the operation,
management, and administration of the Bank."16

This is a sharp break from the past banking tradition in
Korea under which the formulation and implementation of monetary
policy were placed under the direct control of the Ministry of
Finance. According to Bloomfield, the author of the Act, a central
bank is much too strategic and vital a factor in a country's

financial and economic welfare to be guided by any one men or any

one narrow group, no matter how well intentioned.1'7 This idea was

La‘

1aBloomfieldand Jensen, op, cit., p. 43.

1 5 1 he k fKorea Article 7.

171Bloolmfield and Jensen, 9;, git., p. 44.

.....

tradition se-
ponted into no
introduction 0:
dema‘ic ird
mansion of a
political press
0f *1: Board.

the Iowa” 30
ing m: 4}. m
‘0Pm1de in .1
‘h' Bank of Ken
1‘ is felt in a:
lining: of Fine
mm“ 9011'
1"” in h: m

34
a tradition set by the Federal Reserve System, and recently incor-
porated into many central banks of underdeveloped countries. The
introduction of this principle was to make the Korean banking system
democratic and independent from political influences. However, the
provision of a necessary degree of ”independence" of the Bank from
political pressures is somewhat doubtful because'of the'membership
of the Board. The Minister of Finance is an ex-officio member of
the Monetary Board and is charged with the responsibility of presid-
ing over the meetings of the Board.18 The Minister of Finance heped
to provide an avenue of communications between the government and
the Bank of Korea and to ensure the coordination of two organizations.
It is felt in many countries, however, that the presence of the,
Minister of Finance or his deputy on the Board is likely“ to have an
undesirable political influence. This was observed by Bloomfield
later when he revisited Korea in 1952 to investigate the performance
of the Bank of Korea. He states:
Although the Bank of Korea Act explicitly provided that the
determination of the monetary, credit and exchange policies
of the Republic of Korea would be the exclusive responsibility
of the Monetary Board-“the Minister of Finance being but one
of seven members, although the most important single member--
it was, of course, recognized that some time would probably
have to elapse before this notion would be fully understood
and accepted in a country where tight Ministry of Finance
domination of the banking system had so long been the
tradition and the rule. There is in fact some evidence that
the Ministry of Finance has not as yet fully adjusted itself

to the new democratic principle incorporated in the
institution of the Monetary Board.1

 

1 Be 1 of a Article 8 and 9.
19

Arthur I. Bloomfield, Re and Rec t ns n Bankin
W (Seoul: Bank of Korea, 19525, p. 23.

(7.3

’ I
't
. .
,.
r
n
O
,
. ..
J l‘
J I
r- '
0
v
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I“- "I I
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§ .....
Q.
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The '0th?
m over the mag
baking WV“ as . '
discuss“ "1°"

A. Th- W"
ruin- ratios of "5'
not be less than 10 P‘
in periods of promun‘
ing institutions *0 Eli
aqunt incnases in d
m on mich such req
also fix different min
classes of deposits.20

Re In “09“

 

_35

The Mbnetary Board is, at any rate, given extremely wide
powers over the management, administration, and operations of ‘the
banking system as a whole. The major powers of the Board are
discussed below.

A. The Monetary Board is ewowered to fix and alter the
minim- ratios of reserves to deposits. Minimun reserve ratios may
not be less than 10 per cent or normally more than 50 per cent, but
in periods of pronounced inflation the Board may require other bank-
ing institutions to maintain 100 per cent reserves against any sub-
sequent increases in deposits above the amounts outstanding on the
date on mhich such requirements become effective. The‘Board may
also fix different minimum reserve requirements for different
classes of deposits.20

B. The Monetary Board will also be able to exert a measure
of control over the credit Operations of other banking institutions
by altering the rates of discount.21

C. Due to the ineffectiveness of the discount rate policy
in the underdeveloped money market, the Monetary Board is empowered
with flexible rules of eligibility quite contrary to the rigid rules
of eligibility of the traditional policy of a central bank. This
provision of flexible rules of eligibility is to emphasize the role
of discount as an instrument of selective control, rather than a

tool of credit control. The discretionary power of the Bank,

therefore, to accomodate credit to the banking institutions is

2015 Act Egtmlishgg the Bank of Korea, Articles 56, 57 and 58.

211b1d" m1C1. 720 ‘

 

gnu Iith a side rang

wattle: of paper e1

a. Th
buy, an sell
credit docunmr
Deaths, acquij
4” Wat 1(
0f 11:1in “3
Mishable 90¢

'mhouse s . 22

b- n

‘0 one “31‘ f:

m “Kb Cred

 

36
great with a wide range of types of paper and a greater length of
maturities of paper eligible for rediscount.
a. The Bank is authorized to rediscount, discount,
buy, and sell promissory notes, bills of exchange and other
credit documents with maturities of not more than six
months, acquired as a result of operations associated with
the importation, exportation, purchase, sale, or transport
of readily saleable products, and udth the storage of non-
perishable goods insured and deposited in authorized
warehouses.224

b. The maturity of eligible documents is extended
to one year from the date of their acquisition by the Bank
and such credit will cover the documents associated with
the production or processing of agricultural, pastoral,
mineral, fishery, or industrial products.23

c. Moreover, the Bank is authorized to grant
advances in periods of grave emergency when monetary and
banking stability is directly threatened against the
security of any assets which the Monetary Board, by a
vote of at least five of its members, defines temporarily

as acceptable collateral.“

 

amide, ”161. 69 (.)g 2, 3s
23m" Article 69 b.
“My, M101. 69 Ce

' .3

an-.- ~v

 

d. A
prescribes the
Rm in such t
count rates ca
as essential t
D. Sales and
‘h' 0991! Ink” are al
Pmides 'the Oconomic
shauld be conductesz
"the: sh,“ m1”.

conducs op," I ket 0p

Forthisruson’ ,1... B

 

 

 

37
d. A further point of interest is Article 72 which
prescribes the duty of the Monetary'Board to fix the Bank

Rate in such broad terms that a preferential scale of dis-

count rates can be applied to the types of loans considered

as essential to the national interest.

D. Sales and purchases of securities by the central bank in
the open market are also the domain of the Monetary Board. The Act
provides "the economic climates in which the open market operation
should be'conducted.“25 This provision is for the long-run purpose
rather than immediate practical uses because it is impossible to
conduct opendmarket operations due to the lack of security markets.
For this reason, the Bank is equipped udth a stronger power to
issue its own ”stabilization bonds” which can be used in carrying
out Open-market operations}!6

E. The most powerful and frequently used instrsment of
credit control is ceilings on the aggregate volumes of loans,
advances and investment of banking inst itutions.”

_ F. The Board may require, in periods of pronounced infla-
tion, that all applications for loans in excess of specified amounts
mde to banking institutions by their customers be submitted to the
Board for prior approval either for the purpose of quantitative or

qualitative control of credit.28 The Article 66 of the Act does not

 

25m" Articles 90 and 91.
35M" Article 92.
271m" Article 66.

”kids g ”Fri-C1. 66s

s . (30' ‘
‘ . to.

specifically refer to I
provided the Monetary
ceilings in periods of
Besides the a':
of my mi may, i
“*7 *0 fix animal ra
for loans mi “Vances
to asthma other banl
“nit such dsposit; be
One "Y note t
Bank of K0,“. This I
lhich WWI! cgues
hint. 7" c'lltral ba
W ‘h. “chi”. ihat u
Of ‘h 8m 0f Korea.

‘R‘ m
chattel-12°C}

is

 

 

38

specifically refer to the rediscount ceilings. However, the Act
provided the Monetary Board with sufficient authority to impose such
ceilings in periods of inflation.29

Besides the above major provisions essential for the control
of money and credit, the Board is given the power when it deems neces-
sary to fix maximum rates of interest which other banks may charge
for loans and advances to their clients. The Board is also eapowered
to authorize other banks to accept government deposits and to order
that such deposits be transferred to the central bank at any tin.

One may note the wide scope of discretionary powers of the
Bank of Korea. This reminds us of the statement of R. S. Sayers
which strongly argues for the discretionary nature of the central
bank. “The central bank is the man who exercises his discretion,
not the‘machine that works according to rule."30 Such is the case
of the Bank of Korea. The model and techniques of monetary manage-
ment are characterized by an extremely discretionary nature. It is
often said that the discretionary power of the central bank in an
underdeveloped country should be wider and more flexible than those
of a developed country because of the absence of a money market and
external factors affecting the money supply.

The argument for discretion is not free from criticism,

especially from the 'Rule" school. Criticizing the monetary manage-

 

29§_&eg ”+101. is

30R. S. Sayers, gentry Banking 1:33; Bagghot (London: Oxford
University Press, 1957), p. l.

g)

-.-4.-..

T‘.

L—i

H

sent of the Federal F
Eriedm states as f<

The haphazar
ical acciden
none have be
temorary po
credit. The
the tasks of
that more di

FIlOdQIn'; 1
"‘9me the model

in criticis. of dis.

39
ment of the Federal Reserve System, for an example, Professor
Friedman states as follows;

The haphazard assortment of tools reflects mainly histor-

ical accident. Tools have been added from time to time;

none have been substracted except for the lapsing of

temporary power to control consumer and real estate

credit. The resulting collection is poorly adopted to

the tasks of controlling the money supply, and renders

that more difficult.”

Friedman's statement brings out several important questions
regarding the model of Korean central banking. Obviously, Friedman is
in criticism of discretionary policies, and in favor of automatic rule
for unetary management. Professor Friedman's argment is quite
apposed to Professor Sayer's.

The fact that the argument for the "rule" has been developed
our of the long experience of American banking, and the impression
that many American bankers who helped establish the central banks in
underdeveloped countries completely neglected the 'rule" aspect of
central banking, seem to provide good reasons for exploring the
possibility of implementing the ”rule” approach.

This study is not designed to explore this possibility. How-
ever, the findings of this study may point out the undesirable conse-
quence of extreme degree of discretionary policies in Korea.

Though minor it may be, the banking reform also brought
attention to the fact that banking institutions prior to the reform

had many uncollectable assets and meaningless liabilities on their books.

“Milton-Friedman, A Bragg for Monetary Stability, (New York:
Fordhms University Press, 1959), p. 25 and pp. 84-6.

D;

‘Ar

- ' ~ . ’ ----,.. . .

.‘m mcollectible as:
existing banking syst
mageaent of banking

Summit of 9
Wed banking ms.“
bum? °P°ntions in
As describgd in Sectj
3m, tars Pric‘ical]
Despite the early SUE
in *he Gem!“ Bank I

40 all cm shares 0‘

sale of shares of the

1954 [M limos; Comp:

40
The uncollectible assets and meaningless liabilities encumbering the
existing banking system were to be cleared in order to have sensible
management of banking institutions.

Somewhat of greater importance was to sell the shares of the
vested banking institutions in order to have sound and democratic
banking operations independent from the influence of government.

As described in Section 3, all comrcial banks except one, Chcheung
Bank, were practically the branches of the Ministry of Finance.
Despite the early suggestions of Bloomfield and stipulations made

in the General Bank Act, the Korean government had been reluctant

to sell the shares of vested banking institutions until 1954. The
sale of shares of the vested banking institutions was started in
1954 and almost completed by 1957.

The General Banking Act, as a companion measure of the Act
of Establishing the Bank of Korea, was primarily designed to streng-
then and improve the efficiency of the existing banking system.

As criticised by Bloomfield, the Korean govermaent, however, put
off the implementation of the Act until 1954, four years after
the Act was passed in the Congress.32 The Act vaguely defined
banking operations so that comnercial banks could engage in short-

33

and long-term lending operations, contrary to the original draft

of the Act. Comercial banks, however, now engage primarily in the

...hm

‘V

32Arthur I. Bloomfield, op, cit., pp. 20-21.
33The General Banking Qt, Article 15.

 

 

short-an lending OP‘
of business.

Several banki
baking reform should
zed agency for agricu
Federation of the Pin
the Korean Reconstruc
es‘ablisbed as the 5'
Wing Operations 1

05 i special act Ihi

°f Ei‘ablishing #h.

 

41
short-'term lending operations associated with trade and inventories
of business.

Several banking institutions which developed after the
banking reform should be mentioned in this connection. As a speciali-
sed agency for agricultural finance, the Agricultural Bank, formerly
Federation of the Financial Cooperatives, was established in 1956.
The Korean Reconstruction Bank (formerly the Industrial Bank) was
established as the specialized agency for the long-term industrial
lending operations in 1954. The Bank was established on the basis
of a special act which deviates from the basic principle of the Act
of Establishing the Bank of Korea and the General Banking Act..:‘M
The Korean Reconstruction Bank is a government-owned industrial
development bank subject to the close control of the Ministry of
Finance. Furthermore, the Korean Reconstruction Bank is subject to
neither the stipulations of the Act of Establishing the Bank of
Korea nor the General Banking Act. Inasmuch as the sources of funds
are the loans from the government and the issue of its own "Industri-
al Debentures”, which were sold to the Bank of Korea, the Korean Re-
construction Bank emerged as the strong engine of inflation in Korea.
5 fo F c l 1 ions

A brief description of informal financial institutions

should be made in this section. They comprise various types of

 

- 34Arthur I. Bloomfield, Report and Recomnendations on the

Korea Reconstrgtion Bank (Seoul: The Korean Reconstruction Bank,
1960), p. 35 and p. 58. See also Yun Dang, ”The Start of the Korean
Reconstruction Bank, ”Monthlx gulletin (Seoul: The Korean Recon-
.trmtiofi Bmkg OOfObOr, 195‘). Ppe 4.10e

may lenders who fol
financial transaction
long history, an! the
find pawn.” Most
nfara, lardlards and
lenders. After tho 1

Mitipal aoney lende

The family is
my‘m‘rd'Wbped c
also plays an import a:

18 In m‘l‘ll‘lou Of .

 

42

money lenders who follow non-standardized or informal practices in
financial transactions. In Korea the informal institutions have a
long history, and the institutions developed in a rather diversi-
fied pattern.” Most are short-term money lenders. Before land
reform, landlords and merchants performed the main role of money
lenders. After the land reform, however, merchants emerged as the
principal money lenders.

The family is an important financial institution as it is in
many underdeveloped countries. "Jeun Dang Po“ or "Mortgage House”
also plays an important role. The most important is 'Kei". 'Kei"
is an institution of ancient origin in Asia, which is a micro-scaled
mutual aid bank. In this "Kei", family, friends, merchants and
various occupational groups are all integrated into a powerful
institution.

The "Kei" was superceded by financial cooperatives after
1910. In 1950, however, the Japanese administration used the 'Kei"
organisation as the sub-structure of the financial cooperatives.
During lorld Iar II the 'Kei" virtually ceased to function as an
official organization. After the liberationof Korea, the 'Kei"
grew rapidly. Today, hundreds of different types of unit exist.“

It was said that the total transactions of these "Kei" were

 

3"’Kom Yoong Sa; "History of Financial Institutions" in
Koum Young (Seoul: Koum Yoong Sa, June, 1954), p. 145.

“Kim Sam 300, ”History of Kei" in m (Seoul: Jae
Jeung Sa, data unavailable), p. 69.

..-_..-"‘

...
1 t w I
II
1‘ .
v . ' A‘ K .
a .
d. - J
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. 7 t
.7 . 15:." '
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39“” than those l

m an '1:
“w. of +13 scones
formal *YP“ °f fine
tht only access is ‘
of those informal mo
primlly due to the
them, lukets ar

masons. Because of

an localities and th

inlicatlon for the

43
greater than those of comercial banks in 1955.

The term I'informal" may connotate the indigenous or non-money
sector of the economy in which the public lacks the contact with the
formal types of financial institutions. lhen the need for money arises,
the only access is the informal institutions. An unique characteristic
of these informal money markets is an unusually high rate of interest,
primarily due to the inelasticity of demand and limited supply. Fur-
thermore, markets are imperfect due to customs and other sociological
reasons. Because of this, the rates of interest vary widely depending
on localities and the interest rate structure is unintegrated.37 An
implication for the efficacy of monetary management is that these
markets are very insensitive to the actions of the central bank.

Far more important institutions, other than these indigenous
types of money lenders, are the ones that are located in city areas.
If informal institutions imply only these existing in the non-money
sector, it is a gross misunderstanding in the case of Korea. The
'Kei" located in city areas are the sources for consmaer credit and
for the funds associated with high-profit earning and speculative
business activities. That is to say, these are the short-term money
markets in Korea. As will be seen in the next chapter, bank funds
have been allocated only for the uses of productive investment and

govermnt deficit. In formal money markets short-term credit is

 

37For a detailed description see U. Tun lai, "Interest Rate
Outside the Organized Honey Markets of Underdeveloped Countries,”
Stagf zmrs VI, No. 1 (Washington, D.C., International Monetary Fund,
SOPtOmbIr, 1951). PP. 80’1‘2e

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no‘ nomlly nailabl

   
   
   
 
 
  

Those infoma‘
'mflvion in Korea.
from productive activ"
'JOSpi‘O a formal pro?
W: I 1&9! pm of

iMiYidUill m .1150:-

‘1' mud“)? of com
“313*! 18 tin; ‘Yny
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high infirm “+93 c

Mild“. “t 1'1‘ 1. ‘

high 111“” 114‘, ‘

activities. So long

I
5
A 311qu film“
mht‘.

‘1'

44
not normally available except for the arrangement of overdraft.

These informal money markets have grown rapidly because of
inflation in Korea. The persistent inflation has diverted the funds
from productive activities into speculative and high-profit activities.
"Despite a formal prohibition on loans for speculative purpose, more-
over, a large part of the bank loans, especially those to private
individuals and enterprises, is believed to have been used to finance
the hoarding of COIIlOd1+108o'38 A particular importance of these
markets is that they are very sensitive to changes in the price level.
Interest rates are high and move together with the price level. The
high interest rates continue to attract the funds from other less
profitable activities to high-profit activities. At the same time the
high interest rates squeeze the incentive for productive business
activities. So long as inflation persists, there will be a big
discrepancy between the rates of interest in informal and formal
markets. It is this discrepancy of interest rates that makes the
discount rate policy ineffective as will be seen in the next chapter.
The actions of the central bank have only indirect impact upon these

markets.

 

38kthur Io BIONICM, OE: Cite. pa 38s

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THE

1, Etmuction

There are no
mat. Conventionallj
has been to influencc
Wit and other close
in *he United 9.4,"

“a“!!! poll
1* does in th develc
"MW“ tools. The
P105193 “Ch m at
oceanic d.“ 10mm
““ing in “oh the
10cm“: in! *he p
+a Prevailing Circum
In +111; Chap
Of mm”, "Hague

0f ‘1‘ “hauls! es.

 

CHAPTER IV
THE SCOPE OF mNETARY MANIGEMENT

1 nt on

There are no universal rules or techniques of monetary manage-
ment. Conventionally, the primary concern of a central bank policy
has been to influence or control the conduct of the commercial
banks and other closely related financial institutions, as observed
in the United States Federal Reserve System and the Bank of England.

Ionetary policy in underdeveloped countries will not work as
it does in the developed countries if policies are based on the con-
ventional tools. The central bank in Korea faces different types of
problems much are absent in developed countries. The stage of
economic development and socio-political institutions constitute the
setting in which the central bank must function. The choices of
techniques and the patterns of control, therefore, must be relevant
to prevailing circumstances.

In this chapter attention will be focused upon the techniques
of monetary management. The analysis will include the effectiveness
of the mechanism established by the various banking reform measures
in comarison with conventional norms of central bank techniques,
with a particular emphasis on the lack of money markets. So doing,
a description of the scope of monetary management in Korea will be
given.

3, IE Qgeg gf Ems and mlifitigng for $9312! Eoligy
One thing clearly observed in Table 2 is the increased value

45

of assets of comer-oi:
206,329 alllion him 5
flu +0 inflation, sale
reassessed values and

Isms of com
55.6w cent of total
blah: than in develo;
Sum COI-l‘clll ban;
Loans, throughout the
some: of +13 banks'
“mm v as Bando

0mm deposil
btsidu t}. ,1" Capil
*1II “posit; increasl
‘1! damp, Mrstaj

53;: l
1’” °°Imrcia1

 

46
of assets of commercial banks from 384.4 million hwan in 1949 to
206,329 million hwan in 1960. The rise of the value of assets was
due to inflation, sales of vested shares of commercial banks at. the
reassessed values and the reassessment of the fixed assets of banks.1

Loans of comercial banks comrised 67.6 per cent in 1949 and
55.6 per cent of total assets in 1960. The ratio of loans is somewhat
higher than in developed countries. For example, loans of United
States comercial banks were about 42 per cent of total assets in 1956.
Loans, throughout the period under study, have exceeded the domestic
sources of the banks' funds. Other deposits conprise foreign currency
deposits at the Bands Branch Office, Chcheung Bank.

Demand deposits and time deposits are main sources of funds,
besides the time capital stock of the banks. Since both demand and
time deposits increase as the loans are made, the size of demand and
time deposits overstate the genuine sources of domestic funds. The
fact that comercial banks make loans beyond their own sources of
funds is a coenon criticism in Korea. For example, in the first
quarter of 1952 about 80 per cent of loans for industrial plants and
equipment were reported to be made by banks on the basis of rediscount.

at the Bank of Korea.

 

1Since the liberation Korean banks have maintained their fixed
assets at pre-liberation values despite the rapid inflation. Following
the recomendation made by Bloomfield and Jensen, an Appraisal Comittee
for Reassessment was established. But the action was delayed until 1954
due to the reluctance on the part of the government.

21'}: Bank of Korea, 'Quarterly Recomendation by the Monetary

Board,“ in 1h! Five Ten; of :5 my, gf Kma (Seoul: The Bank of
Kon‘, 1955), p. llle

.ps..

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9:!

STATEMENT

ASSETS

 

Canon: 8 Checks

Currency

Checks i Bills
D‘Posits Iifh
drastic banks

friend 3m,
neuritic:
IndWrisl

F .
..un‘ms mint. 11

.Lms

31113 digc
omred

if“ 0% 8111.

hard“;

M

E‘U‘h K 25” 194
in We 5
m D. "

spp

47

TABLE 2
STATEMENT or capnxons 05 ALL COMMERCIAL BANK52

 

ASSETS 1949 1955 1960

C n 8. a 75.22 (19.5%) 15,996 (30 %) 55,218 (26 %)
Currency _ 20.03 1,338 3,791
Checks 8. Bills 20.77 4,706 33,869
Deposits with 34.42 9,952 17,558
domestic banks
M 1,697 ( 3.2%) 13,649 ( 6.6%)
National Bonds 1,691 2,981
Securities 6 7, 168
Industrial Financial 3,560
Debentures
Loans 260.15 (67.6%) 30,815 (57.8%) 114,726 (56 %)
Bills discounted 519 1,444
Loans on Bills 29,540 107,790
Loans on Deeds 3
Overdrafts 753 5,492
mm: _&_4 4 (12.8%) ____Q§8 __.__22 736

384.8 53,313 206,329

 

*This includes foreign currency deposits at the Bando Branch
Office, Choheung Bank. Government Agencies' deposits range 20-25%-

"This includes loan funds from the counterpart funds, UNKRA
small Industry Loans and other. Loans to Government Agencies range

20-25%.
2For 1949, Bloomfield's statistics, in Baking Reform in
W p. 79. For 1955 and 1960, 1;! Economig Statistics

Annual, 1961, pp. 40-43.

I o J
C
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u
u .
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115311.17 IES

 

Doggsits
Dam) DIposits

713 Deposit;
Wurst

Borroiings
PM Bank Of Korea

“than"
VW. hp.

0‘5" at3111" ies
W

 

"_"_

3

1
3

 

48

TABLE 2 Continued

 

LIAB ILlT IE5 1949 1955 1960
Dgpogits , 333.8 (84.2 %) 36,910 (69.2%) 141,011 (68.3%)
Demand Deposits 323.9 25,261 67.648
Time Deposits 2, 975 40,984
0thers* 9.9 8,674 32,379
M 26.52 ( 6.9 %) 13,443 (25.2%) 36,186 (17.5%)
From Bank of Korea 26.43 13,020 26,668
Others" .09 423 5,418
Vest Prop. 4,100

W 23.9 ( 6.2 %) 2,970.5 ( 5.6%)

Cmitgl Aggounts :52 ( .13%) 21.5 ( .2%)
384.8 53,313

10,954 ( 5.3%)
18,178 ( 8.8%)
206,329

u - - _ -.—.

The ratio of

 

 

 

t‘mug‘mmt the period.

    
  

policy inch has beer.
poiicy has bean vary

Except for o

49

The ratio of loans, however, shows its declining tendency
throughout the period. This is largely due to the loan ceiling
policy which has been in force in various forms from 1950. The
policy has been very strict since 1955.

Except for overdrafts, most loans have maturities of not
more than one year; and a few, up to three years. Many of the loans,
however, are delinquent.

Although most of the bank loans to private parties and to
Government Agencies were ostensibly grantedonly for periods
of up to one year, an apparently large fraction of them
remained outstanding for longer periods, and in effect
became long-term loans, in view of lax attempt at loan
collection and easy renewal policies on the part of banks.
(The rice loans are a conspicuous exception.) Despite a
formal prohibition on loans for speculative purpose, more-
over, a large part of the bank loans, especially those to
private individuals and enterprises, is believed to have
been used +6 finance tn. hoarding of commodities.‘

Another study made by an American banker seems to indicate
that the loans adaich were made on the basis of government guarantee
are hard to collect, and those loans, in effect, became the perma-
nent loans.5

Another disturbing aspect of comercial bank lending is the
alarmingly high ratio of loans unsecured by any form of collateral;
the average ratio of such 1oans_appear to be over 50 per cent.6

The proportion of investments increases steadily and rapidly.

 

‘Arthur I. Bloomfield, A Repgzt and Recggndations on nggg
in South Korea (Seoul: Bank of Korea, 1952), p. 38.

1"‘Bank of Korea, Economic Annual, 1955, pp. 1-534.
chloomfield, 92, cit.,-p. 33.

.‘
,
.-
I
\.
f" 1'
..
,.
."
‘-
.
(I
I I
’2
,
g.
Q J
L
I.
I .x
s J
l , a
‘r' ‘-—v
-3 .
J.

.-...~

‘1

311949 there was 1
finance debentures
eerily sold to the
occasion of advance
at composd of the
of 1am refom, bor
corporations. The
Reconstruction Bani
lcnq-‘em bonds. 1
strike a balance be
m nqtfidlty in 11»
We“ dun-1m in

This ‘imple

b . ~
irks brings 013‘ If

lane
9'3"”. The 1r

ing is "may

50
In 1949 there was no investment in government bonds, industrial
finance debentures or other securities. National bonds are compul-
sorily sold to the commercial banks by the central bank on the
occasion of advances or rediscount at the central bank. Securities
are composed of the ”certificates of land-sales“ issued on the event
of 1am! reform, bonds issued by the local governments and by some
corporations. The financial debentures are issued by the Korean
Reconstruction Bank guaranteed by the Government. All of them are
long-term bonds. It. is obvious that there is little attempt to
strike a balance between the banks' needs for safety, solvency,
and liquidity in the composition of a bank's portfolio, as is so
often described in conventional money and banking texts.

This simple study of the uses of funds by the commercial
banks brings out an important point in the context of monetary
management. The inclination of the banks for inflationary financ-
ing is evident. In a non-inflationary economy, the banking system
transfers savings accamaulated by householders into investment
activities.7 A well-developed banking system facilitates the
behavior of saving. To some extent, a banking system can expand
credits more than what householders desire to save in order to
enforce forced saving. However, the degree observed in the Korean
situation seems very great.

In this connection, the absence of the short-term markets

and its effect on the effectiveness of monetary management should

 

7D. Robertson, Essgn in Monetary Theory (London: Staples
Press, 1956), p. 53.

.....

be stationed.
Except for
loan lake‘s, such
acceptances in for
ten loans are fin
the central bank h
securities are 1551
the shortening of g
‘6! bonds, which 1
Honey and y
5““ ‘hough eh". i

the lack of economy

gm‘h Of ‘h' Inirks
0m: for th. 91’0"?
rate of Personal In

bold tl’n "Vings in

51
be mentioned.‘

Except for the overdraft practices, there are no short-term
loan.emrkets, such as call-loans, commercial bills, and banker's
acceptances in formal markets. Host of the demand for the short-
term.loans are financed by the informal money markets over which
the central bank has only indirect and remote control. Government
securities are issued exclusively in forms of long-term securities.
The shortening of maturity of bonds provided existence of the short-
term.bonds, which markets, however, are narrow'and unorganized.

Money and capital markets do not develop in a vacuum.

Even though there exists a somewhat well-developed banking system,

the lack of economic activities, especially trade, hinders the

growth of the markets. Another limitation, perhaps the fundamental
one, for the growth of the capital markets in Korea, lies in the low
rat. of personal and business saving. Besides, some savers prefer to
hold the savings in the forms that remain directly under their control,
such as real estate, foreign exchanges and gold.

Conventional tools of monetary control which developed out
of the london market can be effectively used only when there exist
well-developed short-term markets, which in turn have sensitively
structured suquarkets. lhen such markets exist, as in London or New
York, the strain on the banking system is first felt in periods of
pressure. The central bank, therefore, usually confine its Operations
to the short-term money markets. The existence of such money markets
enables the banks to maintain a fixed and minimum.ratio between their

deposits and reserves. The central bank thus can control the money

(e

."i

(D

(
0"e

I.

_‘

 

urkets me
i‘y cordit
7h
*‘m absenc
reserve ra
denlcped
Cu
"Wing be
*ypically
sector in

flint-nae if

”‘1’ 4! hit
Wbstm‘i

Easing be

it .
‘ia‘l p:
a, H

‘.

52
markets merely by watching and adjusting the cash balance and liquid-
ity conditions of the commercial banks.

The agricultural characteristics of the Korean economy and
the absence of money markets make the maintenance of a fixed deposit
reserve ratio by the banks impossible, as is true in other under-
developed countries.8

Currency composes a high preportion of the total money supply,
varying between 35 per cent and 65 per cent. Agricultural sectors
typically do not use checks; we have seen the preponderance of this
sector in Korea. Consequently, the use of currency is great and
fluctuating. For example, the ratio of currency over demand and some
time deposits which are included in the definition of money supply
was 2.8 in 1945 and 3.8 in 1960. This indicates that the use of
currency has been. increasingly important in the Korean economy.

Thus, bank holdings of currency vary greatly. In fact, any
flow of currency into and out of the banks causes simultaneous changes
in the reserve positions of the banks. The banks, therefore, habitually
keep a high ratio between their cash reserves and the deposits. Pro-
fessor Bloomfield states that the reserves and reserve ratios underwent
substantial fluctuations during 1945-1951, the latter generally fluct-
uating between 15 per cent and 30 per cent.9

Suppose there are well-developed money markets in Korea, the

ratio would be lower because banks would certainly invest idle funds,

 

8A. Bloomfield, ”Monetary Policy in Underdeveloped Countries",

W (A Yearbook of the Graduate School of Public Administra-
tion, Harvard University Press, 1951), p. 241.

9A. Bloomfield and J. Jensen, B k Refo in South Ko a
(Seoul: Bank of Korea, 1951), p. 39.

t .
.....

~o.” ‘

if my, in short-t
3. market
Open marks
pomrful tools of .
essence of these 01
whet on its init
change the supply .
"um P0391011 0
changes in the non
Outside th
an a full-fledged
Wm! the Uni.”

hm Hm: been c<

53
if any, in short-term markets.
3. Qanflkgt mrations

Open market operations of some forms are considered the most
powerful tools of credit. control in money and banking textbooks. The
essence of these operations is that the central bank goes into the
market on its initiative and buys and sells its assets in order to
change the supply of funds in the market through the changes in the
reserve position of comercial banks and to bring about desired
changes in the money rates and credit conditions.

Outside the United States, however, open market operations
are a full-fledged credit policy instrument in only a few countries,
notably the United Kingdom and Canada. In Korea open market operations
have never been conducted. The provision of open market operations is
only for the longfrun purpose.

The fact that open market operations have never been conducted
in Korea basically reflects the lack of institutional arrangements.
First of all, the lack of well-developed money and security markets
makes it. impossible for the Bank of Korea to buy and sell securities
on a considerable scale in order to affect the reserve positions of
ce-ercial banks without affecting security prices seriously. The
essential element of open market operations is that the operations
bring the central bank into ”contact-'10 not only with the volume of

available bank reserves, but 5 also with the portfolio of all classes

 

10R. V. Rosa, ”Interest Rates and Central Banks,” in Money,
W (New York: Macflillan Co., 1960), p. 280.

VVVVVVV

 

of lerders. The a
no basis of contac-
The absencq
sakes the liquiditj
ma argxm that thq
denIOped countriu
action purposes.11
elastic. Open mark!
I‘ '33 W11
“'9 a fixed N‘io
‘th um"5“3I1ce l
m. bmn- ,mss :
ibility of Credit
Even if ‘h

order to “feet ”A

““9831:
I1:

54
of lenders. The absence of the money and security markets provides
no basis of contact between the central beak and commercial banks.
The absence of short-term liquid assets in organized markets
makes the liquidity preference function interest inelastic. Sou
even argue that there is no speculative demand for money in under-
developed countries ard the demand for money is strictly for trans-

11 "If the liquidity function were not interest-

.12

action purposes.
elastic, open market operations would be impracticable.

It was pointed out that cannercial banks have not sought to
keep a fixed ratio between their cash reserves and the deposits. In
this circustance central bank securities sales may merely reduce
the banks' excess reserves and may thus fail to restrict the avail-
ability of credit from the comercial banks.

Even if there is a basis for open market operations, there are
additional obstacles. The operations must be on a large scale in
order to affect the reserve positions of comaercial banks. This
necessitates a wide fluctuation in security prices finish is detri-
mental to the growth of the security market. Conventionally, canner-
cial banks in Korea have heavily relied on the central bank for
advances and discounts. This may also nullify the potential effect
of open market. operations.

Open market operations in developed countries work in both

 

11S. Ghosh, Inflgtion in g; Underdevelogg Egonomy (Calcutta,
World Press, Ltd., 1959 , P. 48. .

12.1. I. Keynes, A Mgtig o9 Money (New York: Harcourt, Brace
coo, 1956), pm 1970

-.-_‘

(I

i‘“

.—
s
..
, O .
l .-.
..
I ‘e
. I
t’.
._ r
”I
7.-
' I
a J.— n
;
".‘
- ll.
;_. a
L m
o.
O
r -."‘
.L ). -
,. g l‘
u» — ......
. {I
. .' f

 

directions: in
apen mint 0;
in {cm withj
government is:
abou‘ 55,000 I
about 30,000

1961.13 It 1
"On in a 11:
than i pone
“Home“ a
business as
‘Yi‘n mg

in ‘h‘ mam
mm be 3‘
“10!: N 1
“$1011; re
‘5' nos. 1
in Korea.

Inns; in,

in Chapi,

“(133.2!
4 n

W

\

N
\

55
directions: in contracting and expanding the money supply. However,
open market operation can not be used in contracting the money supply
in Korea within a foreseeable future. Since the Korean war the Korean
government issued about 128,772 million hwans of national bonds and
about 55,000 million hwans of industrial reconstruction bonds. Only
about 30,000 million hwans of both bonds were redeemed by the end of
1961.13 It is not difficult to carry out the purchase transactions
even in a limited market. But the matter would be entirely different
when a policy of contraction has to be enforced not only because of the
narrowness of markets, but also because of the low rate of private and
business savings. Host of the bond issues are held by the banking
system and only a small portion of the bonds are sold to the public
in the manner of compulsion. In this circmstance, finding the buyers
would be more difficult than finding the sellers. Despite the limit-
ation and weakness of imlementing open market operations, the pro-
visions regarding the operations in the Act of the Bank of Korea is
the most important contribution for the future monetary management
in Korea. Judicious uses of the operations will provide greater
monetary stability in Korea. This specific point will be elaborated
in Chapter VIII with reconnendations on the techniques of monetary
management.
4 D co ol c

The discount rate is the primary means used to influence the

 

13The Bank of Korea, The Ec n ' Sta tic Annua , l 1.
(Seoul: Bank of Korea, 1961), pp. 130-131.

(\

aom‘ of discc
ngudcd as M
m. Thm a:
ing sown-y cc
hid: the traii
the: i: a: an
figment.

It fell
‘hat +1. mm

1M“? rites

Gummy, to *h

56
amount of discounting. The discount policy is therefore generally
regarded as being concerned exclusively with setting the discount
rate. There are essentially two roles of the bank rate in perform-
ing monetary control. One is as an instrument of credit control,
which the traditional theory of central banking focused on, and the
other is as an instrument of credit accommodation, which is a recent
argument.

It follows from the underdeveloped money and capital markets
that the interest rate structure is largely unintegrated and that
interest rates are relatively insensitive, over the large part of
economy, to the actions of the Bank of Korea.

In the literature of central banking, the discount rate has

been seen as serving some or all of five purposes that Professor

Sayers states:1‘

A. As a penalty rate, operating as a fine on unreason-
able timidity;

B. As a governor of international capital movements;

C. As a check upon the accumulation of stocks of
commodities:

D. Through its influence upon the whole structure of
interest rates, as a regulator of the demand for
real resources to be embodied in fixed capital:

E. A. m ”M.XO.

None of the above functions are served in Korea partly because

of the absence of money and capital markets and partly because of the

 

“a. s. Sayers, 02:21:11. flanking Aim; nghot (London: Oxford
University Press, 1957), p. 123.

lmihe traditional emphasis of bank rate as a weapon of the
central bank rests upon its remarkable effectiveness of protecting
the Bank of England's gold reserves in the period inediately before
1914.

absence of econoni
fessor Rosa exit in
*‘m trditional th
m ‘10 links conn
contact: the bank
IIIh‘ rats to :15,
neither of these "
‘ional theory and
0f controlling ‘he
mama, Rosa 1
”‘3‘" uncertain.

'A dun“: hOIEVI

57
absence of economic conditions similar to developed countries. Pro-

16111

fessor Rosa criticizes the traditional theory of bank rates.

the traditional theory of central banking, according to him, there

are two links connecting gold reserves with the bank rate: one which

connects the bank rate and market rates and one which connects the

market rate to the behavior of borrowers. He sees the existence of

neither of these "connections“ required for the validity of tradi-

tional theory and‘practice. As an alternative, Rosa suggests the need

of controlling the supply of funds rather than demand for funds by

borrowers. Rosa claims that a little change in interest rates

creates uncertainty, whereby the supply of bank funds can be controlled.

"A decline, however slight, if sustained for any appreciable length

of time will create uncertainty over the possibility that credit may

be turning generally easier....And oftentimes the mere indication of

a change in the direction of rate movements may be enough to transform

many of the dominant institutions from willing to reluctant leaders,

or the reverse."1'7
The argment described above is whether it is the supply blade

or the demand blade of the scissors that does the cutting, with

respect to interest rates. This is similar to the argtnent between

the banking school and currency school in its emphasis, though their

1%0", 02: Ci‘fe’ pp. 273-2760

1u’Ibid., p. 286. As far as the «phasis on the supply side is
concerned, it seems that many economists support Rosa's argument.
C.F.: 0. Veit, "Changes in Monetary Policy and their Consequences to
Banking," in Relations mtween the Central Bank 9;! Connercigl Bank!
(Frankfort on Main, Fritz Knapp 8. Veriag, 1957), p. 16 and Bloomfield,
"Monetary Policy in UnderdevelOped Countries," cg, git" p. 234.

......

........

 

issue was concerned

In Korea de;

   
  

of Korea was great
m Iould have work
discount rates of t“

“W in males 3

”°‘: ‘hl incentivg fc

Bank 0f Korea. The

"that “a“ N ‘W

«Nam for bank in”
I?“ fur loins in

mg. 1‘ “u‘llY fr

58
issue was concerned with the forms of money.

In Korea dependence of the banking institutions on the Bank
of Korea was great up to 1958. One might think that the discount
rate would have worked well in these circuastances. Interest and
discount rates of the Bank of Korea and the ordinary banks are pre-
sented in Tables 3 and 4. A substantial difference in rates between
the Bank of Korea and the ordinary banks is observed in the tables.
It should be eaphasized, however, that this difference in rates is
not the incentive for the rediscount of the ordinary banks at the
Bank of Korea. The difference in interest rates between formal
market rates and the rate of informal markets is so great that the
demand for bank funds always exceeds the availability. Interest
rates for loans in the informal markets vary considerably, but the
range is usually from four to ten per cent per month. Though various
rates were raised a substantial degree both at the Bank of Korea and
the ordinary banks, this increase in bank rates was far too small to
curb the demand for bank funds. On the supply side it is the govern-
ment policy, friendship and reasons other than the interest rates
that control the supply of bank funds.

It is doubtful, under these circumstances, whether or not the
interest rates do the cutting at all, either by the demand blade or
by the supply blade. Even in developed countries we know ”little
about the connection between changes in particular interest rates

and in the money supply."20 Especially in Korea, the discount rate

 

”unmarried-an, A Prm for Monetary §tgbilitx (New York:
Fordham University Press, 1959), p. 35.

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we: of in‘ms‘ a:
fessor Friednn is ‘

is follm:

 

Ancim‘ ex
alrmy ref
«anemic 1d
Keynes led
Offectg of
'crodiu of

1‘ seems c1
nei‘her m credi.

COW» “‘03 have b!

bmk “Eds ‘0 pmft

”fluxes.

61

policy has been insignificant as the effective policy instrument. In
this connection it is instructive to note Friedman's distinction be-
tween the “monetary" effects of the discount policy - the effects on
the stock of money and the ”credit” effects - the effects on recorded
rates of interest and other conditions in the credit market. Pro-
fessor Friedman is very critical about the credit effects, stating

as follows:

Ancient example of confusion is the “real bills" fallacy

already referred to. More recently, the changes in

economic ideas associated with the name of John Maynard

Keynes led to an almost complete neglect of the “monetary”

:ffectsuof monetagy policy and concentration on the

credit effects.

It seems clear, however, that the discount rate does bring
neither the credit effects nor the monetary effects in Korea. IDis-
count rates have been used as a purely formal matter in allocating
bank funds to preferred borrowers by extreme degree of selective
measures. As observed in the previous chapter, the Monetary Board
is empowered with.edde discretionary power of eligibility rules.
This wide range of eligibility rules from consumer credit to pro-
lduction credit has been the factor which affects the stock of money.
That is, the ”monetary” effect was brought about by the discretion
of various measures, but not by the discount rates. The effective-

ness of this selective type of control will be discussed in Chapter

VII.

 

21Ib1de, Pe 43a

The aanipul

buks' reserve posi
has much room to be

Asulll he s
increase er decrees.
factors Ihich m o:

oval-drafts, purchas

 

sales of aid goods.

 

62
5 Re o Re men s Polic

The manipulation of the reserve ratio does directly affect the
banks' reserve positions. The reserve requirements policy, therefore,
has emch room to be used effectively in Korea.

Asedll be seen in the next section, the major factors which
increase or decrease the reserves of the commercial banks are the
factors which are out of the control of the central bank, such as
overdrafts, purchases of foreign assets and the collections from
sales of aid goods. Those factors are not only uncontrollable by
the Bank of Korea, but also irregular in their changes. These
irregular changes cause the secondary expansion effect of the money
supply to be highly volatile when there is a low reserve requirement.
Therefore, high reserve requirements provide a cushion to eliminate
the further fluctuation of the changes in money supply based on the
primary expansion effect.

Higher reserve requirements, possibly up to 100 per cent,
have additional merit. When the public sector is dominating the
use of bank funds like Korea, the higher the ratio, the easier the
diversion of resources will be made to the public sector. As will
be analyzed in a later chapter, this provision.wdll largely eliminate
the unnecessary and cumbersome tools of selective control, such as
loan ceiling and selective eligibility rules.

Furthermore, changing reserve requirements has the merit of
simplicity. For these many reasons, there has been a growing

tendency in recent years to resort to variable reserve requirements

in my Warden 10

As see obse
empowered IN: a r;
reserve requirement

Bank of Korea, the

 

‘hl aggregate noun
‘1! reserve require
raised .0 15 per ce
June, 1952, .1“ res
“5 “Mir raised
”Meant: +0 25
20 .391 “n“ for or}.
In adi‘ioJ
a Secondary r“er
the increased d9po§|
For a shore Period,
Karel "fin-“Ont”

 

63
in many underdeveloped countries.22
As was observed in Chapter III, the Bank of Korea is also
empowered with a wide range of discretionary powers concerning
reserve requirements. From the beginning of the operation of the
Bank of Korea, the Monetary Board required 10 per cent reserves on
the aggregate amount of deposits23 in each bank. In April, 1952,
the reserve requirement for deposits of local governments was
raised to 15 per cent, and for other deposits to 12 per cent. In
June, 1952, the reserve requirement for deposits of local governments
was further raised to 20 per cent. Another increase in reserve
requirements to 25 per cent for deposits of local governments and
20 per cent for other deposits was made in October, 1952.
In addition to these successive raises in reserve requirements,
a secondary reserve requirement of 45 per cent was superimposed on
the increased deposits accrued during the third quarter of 1952.
For a short period, from late in 1952 to early in 1953, the Bank of
Korea experimented with the imposition of a 100 per cent reserve
requirement against any subsequent increases in deposits.
The reserve requirement policy, especially in 1952 and 1953,

seem to have effectively resulted in restricting credit expansion.

 

22For an excellent discussion on this issue, see Richard Goods,
and Richard S. Thorn, 'Variable Reserve Requirements Against Comercial
Bank Deposits,” in Stgff Papgrs,VII (1959-1960) (lashington, D.C.e
International Monetary Fund, 1960), p. 9-41.

In April, 1952, the deposits of the commercial banks were
divided into deposits of local governments (including public insti-
tutions and interbank deposits), general time deposits, and other
deposits. In April, 1957, the general tin deposits and other depOsits
were further subdivided into three categories: savings, time and
demand deposits.

o .....

.e
‘.

me credit malt. ipli‘
sm of notes held b‘
ing institutions, 9

significant decl'me

1950 l.
1951 l.
1952 ,
1953 ,
1954 1.
D“. *0 the

 

of 1953, the reser

       
    

cent of all ‘Ypes o

hmr, sh use

3° Per cent.

Experienc,

64
The credit multiplier, computed by dividing total money supply by the
sun of notes held by the public and the Bank of Korea loans to bank-
ing institutions, government agencies, and the private sector shows a

significant decline in 1952 and 19:5324 as follows:

1950 1.055 1955 1. 225
1951 1.046 1956 1. 113
1952 .943 1957 1.071
1953 .832 1958 1.354
1954 1. 137 1959 1.441

1960 1.106

Due to the tight credit condition after the currency reform
of 1953, the reserve requirements were lowered to a uniform 10 per
cent of all types of deposits. As the credit condition normalized,
however, the reserve requirements were raised successively to 20 and
30 per cent.

Experience in Korea indicates that reserve requirement manip-
ulation is the only one of the three conventional tools of credit
control which is in effect presently. In spite of the rather frequent
use of reserve requirements policy by the Bank of Korea, its potential
effect of restricting credit eatpansion was nullified by the mismanage-
ment of other credit controls. Because of relatively easy access to
Bank of Korea credit for the comercial banks, the restrictive effect
of the increased required reserve ratios was frequently evaded by the
con-ercial banks through borrowing the needed additional reserves from

the Bank of Korea.

 

2‘rne very low credit multiplier in 1953 is largely due to the
effect of the currency reform. After the reform, bank deposits
declined sharply due to the fear of blocking the accounts which were
done in the reform.

 

6. The Sources of
Policy

Thl money \
cam has three 54
funds. The proper-1
capital stock, res:
0.2 m cunt in 19:
M Npulates that
“Mnlent to 10

" ‘1‘ Bank of Kort

Wm

“mm

m d”Posi‘

 

 

65

6 he Sources of Funds Addition 1 li ations for Monetar
Policy

The money with which the cousercial banks operate lending
comes from three sources -‘ invested capital, deposits and borrowed
funds. The proportion of the capital account, which is composed of
capital stock, reserves, and profits, was only 0.13 per cent in 1949;
0.2 per cent in 1955; and 8.8 per cent in 1960. The General Banking
Act stipulates that paid-in capital and surplus should be at least
equivalent to 10 per cent of total assets, including cash and deposits
at the Bank of Korea, any deposits in banking institutions outside the
country, and any investments in Bank of Korea Stabilization Bonds.25

The deposits are a rather high proportion of total assets;
84.2 per cent in 1949; 69.2 per cent in 19553 and 68.3 per cent in
1960. Compared with the other developed countries, this ratio is,
however, still IOIh For example, deposits are about 90.9 per cent
of total assets in the 0.5. commercial banks. The 84.2 per cent in
1949 should not be taken as it is because a substantial amount of the
proceeds from sales of aid goods were deposited in the commercial
banks. The high ratio of deposits also reflect the consequences
of increasing loans to government_agencies and the private sector.
‘The rapid increase in time‘deposits from 1955 to 1960 shows the
favorable result of a “saving campaign" to some extent. The increase
of saving deposits can be partly explained by the special arrange-
ment for saving deposits, such as the ”Bord-Saving Deposits,” which

 

25113; General flanking Act, Article 15.

 

was conducted to in

  
   
  
  
  

u! mly issued bc
saving deposits.
lithin the
*he banks to met
an external source

ml 10:: cash, hows

66
was conducted to induce the purchases of government bonds. Existing
and newly issued bonds were allowed to be deposited as the bond-
saving deposits.

Iithin the comercial banking system alone, the capacity of
the banks to create demand deposits is limited without borrowing from
an external source. When the public decides to hold more deposits
and less cash, however, this will increase the banks'capacity to
create demand deposits. This seemed to be significant in Korea in

the net creation of money supply.26

To some extent, the successful
"Bond-Saving' drives also provided capacity for banks to create money.

The most important cause for deposit creation in Korea has
been borrowing at the Bank of Korea. The ratio of this borrowing
increased rapidly from 1949 to 1955, and declined from 1955 to 1960
due to the tight money policy, which has been especially induced in
order to maintain a revised exchange rate.

Since the ability of the comaercial banks to create deposit
money depends on the reserves available, the balance sheets of the
Bank of Korea are presented in Table 5 in order to investigate
several key factors which affect the reserve positions of the com-

mercial banks. The volume of reserves of the banks as a group at.

any moment of time is equal to the assets of the Bank of Korea minus

 

26m all countries, the average percentage change in money
due to the change in K, the ratio of deposits over currency, was
smaller than the variation associated with the change in central
bank monetary liabilities. Cf: J. Ahrensdorf and S. Kanesathasan,
“Variations in the Money Multiplier and Their Implications for
Central Banking,” Staff Pamrs (November, 1960), p. 134. However,
Professor Gambino suggests this was significant in post-war Italy,

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68
all the liabilities of the Bank, except notes held by the commercial
banks and their deposits in the Bank.

Loans to tl'm banking institutions increased steadily during
the period ef tight money policy. One important aspect is the rela-
tive sire of the government overdrafts and its tendency to increase.
Gmrmnt revenues lagged behind expenditures over the whole period
of sttfly. The revenues amount only to a little more than 50 per cent
of government expenditures. The gap between the eXpenditures and the
revenues widened rapidly after 1949. The tax revenues range between
25 per cent and 40 per cent of total government revenues. Major
sources of gevernment revenues consisted of the land tax and profits
of the govermnt nonOpoly on tobacco, salt and ginseng. Other
government enterprises andproperties, such as communication, yield
only little revenues. The majority of government enterprises are
operating at a loss.

In the absence of capital markets and in view of the infla-
tion itself, the government failed to finance the budgetary deficits
byvsa‘les of bonds to the public. As is observed in Table 5, the
national bonds held by the Bank have increased during this period.

In 1949, for elm-pk, 100 million hwan of bonds were issued, only

30 million hwan of bonds were sold to the private sector and those
largely in a compulsory manner. The rest of them were underwritten
by the Bank mich in turn sold them to the banking system. Therefore,
the bond issues are the same as the overdrafts. Industrial
financial debentures sold to the Bank were issued by the Korean
Reconstruction Rank in order to finance the long-term lendings to

industry. The only factor which caused the decline of the reserves

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69
of conercial banks has been the counterpart funds, which are
deposited by the proceeds from sales of aid goods. These factors
are beyond the control of the central bank. It should be emphasized
that the central bank increased the loans to the comercial banks on
top of the fact that the central bank was pressed by external factors
which were most important in affecting the reserve positions of the
comercial banks.

The central bank failed to control the reserve positions of
conercial banks. For this reason, the ceiling of loans to each
comercial bank was implemented in 1950. The loan ceiling policy
has been considered the most, powerful instrunent of credit control
in Korea. However, it seems to be a case of "locking the barn door
after the horse is stolen."

Besides the overdrafts of the government, the loans made by
the Reconstruction Bank were greater than other loans. In 1954
the Reconstruction Bank made about 26 per cent. of total loans; the
conrcial banks 68 per cent; and the Agricultural Bank, 6 per cent,
as presented in Table 6.

{ TABLE 628
PERCENTIGE OF IDANS MADE BY BANKING GROUPS
W Agricultural flank Reggngtmflon 32k
1954 68% 6% 26%
1956 43% 14% 43%
1958 29% 31% 40%
1960 29% A 32% 39%

 

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70

By 1960 the Reconstruction Bank loaned 39 per cent, the
Agricultural Bank, 32 per cent; and the commercial banks, 29 per cent.
This situation indicates that about 70 per cent of the total loans
available in the economy is beyond the control of the Bank of Korea.

In this situation it. is clear that the scope of monetary management is
very limited.

In this section, problems of monetary management in a particular
situation in which the government dominates in monetary spheres are in-
vestigated. lhen the scope of government activities is great, the central
bank can control credit effectively so long as the government balances
the budget. It has been sham that the government deficit has been the
some of constant pressure to the Bank of Korea. The government sector
has been the major cause of credit expansion in Korea. Moreover, credit
expansion to the government sector alone exceeded the optimal increase
in money supply in the total economy, as will be seen in Chapter VIII.

In addition, it is clear that the scope of monetary management
is extremelylimited because about 70 per cent of the total of loans
available in the economy is beyond the control of the Bank of Korea.

In this situation, monetary management may well be considered a branch
function of fiscal management.

In previous sections, major tools of credit control, except
for the loan ceiling policy, were evaluated in the light of the Korean
situation. It was clearly pointed out that the conventional tools of
credit control do not work or are ineffective except in the case of

reserve requirement manipulation.

In view of government dominance in monetary spheres and in-

1.

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71
effectiveness of the conventional tools of monetary policy, a question
concerning the usefulness of the elaborate assortments of tools of
credit control in Korea may be raised. Some of the tools, reserve
requirements and Open-market Operations, may be useful to monetary
management in the future, as wdll be seen in Chapter VIII. However,
the general nature of monetary tools seems to reflect a similarity
to the conventional model of central banking. Furthermore, in antic-
ipation of the ineffectiveness of conventional tools, credit tools
seems to have been armed with elaborate measures of selective control.
This leads to the conclusion that the model of central banking,
designed by the banking reform.measures and adapted by the Bank of
Korea is necessarily complex and elaborate. Elaboration of the tools
of credit management, for example, nullified the potential effective-
ness of reserve requirements, especially during 1952 and 1953.

It is important to note that the more elaborate and complex
the tools of monetary management, the more ineffective monetary man-
agement become, especially when credit expansion is dependent upon
the "pull” and ”push“ of political influence as in Korea. Therefore,
use of simpler tools could have been more effective.

lith these points in mind, attention is now turned to the

behavior of money supply in Korea.

 

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Ie—-—

CHAPTER V
THE mm SUPPLY

1 De in t n of S l

The definition of the money supply is necessarily arbitraty.
Broadly speaking, money may be defined "in term of the supply of
those things, whether physical objects or claims, which are held by
the general public and which are ordinarily accepted as media of
exchange."1 Conventionally, currency in circulation and demand
deposits subject. to check are considered to be money supply.

If attention is focused on money's function as a median of
exchange alone, problems arise concerning the treatment of time and
saving deposits, bankers' balances, government deposits in the bank-
ing system, various other deposit categories and all conceivable
media of exchange.

Viewing money as other than a medium of exchange, Professor
E. 3. Shaw, following the lead generally attributed to Hicks, Hansen,
and others, has argued in favor of extending analysis of money in
relation to economic growth to all forms of debts, one of which is
money.2 The primary reason for such an extension of the definition

of money is that financial assets, other than conventionally defined

 

lJames VI. Angeli, T Bob 0 of Mono (New York: McGraw-

Hill, 1936), pe 6e

2’c. R. lhittlesey, ”Relation of Money to Economic Growth,"
WM!» paper‘ and proceedings. (May. 1952). P- 189.

72

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73
money, possess a significant degree of liquidity. This is imortant
in an analysis of monetary problems. If this is the case, the
definition of money my be further extended to include conodities,
because the co-odity contracts and co-odity hoarding actually
serve the purpose of liquidity, or a store of value, especially
during a period of monetary uncertainty.

From this point of view, there is no proper way to define the
money supply. It seen imossible to define the money supply solely
on a logical ground. Consequently, comromise in the definition of
the money supply is necessary before it my be used in terms of the
existing data.

The money supply as defined by the Act of the Bank of Korea
cemrises Bank of Korea currency held outside banking institutions,
plus all deposit liabilities of banking institutions and of the
Bank of Korea payable by check or otherwise payable on dennd,
except interbank deposits and deposits held for the account of the
government, its ministries, bureaus, and sections.3 This conven-
tional definition has been adopted for this study, with slight
modifications.

The money supply in this study consists of dennd deposits
and currency outstanding outside the banking system plus some time
deposits. A relatively small amount of government deposits held in

co-ercial banks cannot be isolated statistically.

_— _ A; __ *-

Wmmrmmm Article 96.

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74

Thus, these government deposits are included in the computation of
the money supply. In addition, some time deposits4 such as ”Special
Current. Deposits” and "Special Deposits" are also included intro
computation of the money supply. These are not demand deposits
but have been used directly to make payments without prior conver-
sion into demand deposits or currency. These deposits earn interest
on a daily basis and are used by many businessmen to replenish their
checking accounts at the close of each day.5 Bloomfield and Jensen
make a similar statement: “In the case of Korea, certain categories
of deposits, e.g., 'Special Current' deposits, although not. subject
to check, were in fact used directly as media of payment by means of
bank drafts."6

Other deposits, such as, "Bond-Saving" deposits, ”Special
Saving” deposits, and ”Special Bond-Saving" deposits are designed
primarily to absorb liquidity in an economy. Thus, these are not.
included in money supply.

 

‘Several types of deposit accounts exist in the Korean bank-
ing system:

1. Demand Deposit

2. Special Current Account

3. Special Deposit

4. Savings Deposit

5. Bond-Saving Deposit

6. Special Saving Deposit (In-Kind Deposit in Agriculture
Bank

7. Special Bond-Saving Deposit

5International Monetary Fund, International Financial
S:,'!L!!I;S' (Jun.’ 1960), p. 1840

6A. I. Bloomfield, and J. P. Jensen, Banking Refgrm in Soggh
Korea (New York: Federal Reserve Bank of New York, 1951), p. 27.

was.

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75

2, Ens! 529211

The money supply was 105.08 million hwan (10,508 million won
in old currency) in September, 1945. Since then the money supply has
persistently increased until it reached 219,077 million hwan at the
end of 1960. The quarterly data of factors affecting the money supply
is presented in Table 8. In this chapter factors affecting money
simply will be explained in somewhat detailed manner. Since the
money supply is characterized by three distinctive periods, the
analysis will be made in three periods. Prior to these examinations,
however, seasonality and aggregate behavior of the money supply will
be investigated.

A. Seasonal Behavior of the Money Supply

The money supply exhibits a seasonal pattern, as may be
observed in Table 7.

TABLE 7

SEASONAL INDEX OF KNEY SUPPLY ADD DEMAND DEPOSIT VEILXIITY7

 

Seasonal
Index of
Seasonal Index Percentage Demand Deposits Percentage
of money supply Change Velocity‘ Change
1st Quarter 100.23 -5.6% 98.04 -8.4%
2nd Quarter 96.00 «4.2% 96.41 -1.7%
3rd Quarter 97.65 1.7% 98.55 2.2%

 

*Deposit velocity is computed by dividing withdrawals of
checking deposits by outstanding checking deposits. Data available
are for 1952-1960 in IL! Ecgnmg Annual, published by The Bank of
Kon.e'

7Seasonal indices are constructed by the centered moving
average method from 1946 to 1960. The years of 1950, 1951 and 1952
are excluded because of highly disturbing effects of the war. The
Autunn Moon Festival comes on a variable date on the western calendar.
However, it does not move between quarters. The seasonal indices are
not aijusted to this variability.

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g 76

The money supply tends to increase from the third quarter
(harvest season) and reaches its peak in the fourth quarter (Christmas
and New Year). From the first quarter to harvest season, the money
supply declines. This reflects the characteristics of the agricul-
tural economy. Tradition seems to have equal importance in such a
seasonal behavior of the money supply. First, people have strong
attachments to the "Autmn Moon Festival” which is similar to Thanks-
giving in the United States; and second, people customarily attemt
to stock one year's supply of rice, essential food stuffs and fuel
during the harvest season, which involves greater expenditures and
an increased transaction demand for money.

During the harvest season government and banking systems
pour a greater amomt of money into the agricultural sector. The
government purchases rice, tobacco, silk, and other farm products.

The purchase of rice has special significance in the Korean
economy. The age-old tradition has been to secure and reserve
strategic foodstuffs in order to meet possible national shortages.
The tradition, however, is misused by securing rice at a lower cost
in order to distribute it mong public employees in lieu of higher
salaries. This was practiced by the Japanese in the past and
presently by the Korean government.8 The tradition was also to
stabilize the rice price and thus, the general price level. This
objective was rather secondary.

8Grain management conducted by the government made a sub-
stantial profit before the Korean lar.

 

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77_

The Agricultural Bank and other banks make enormous loans
to the agricultural sector and other economic activities associated
with agriculture during the harvest season. Credits to farmers have
been very important because more than half of the farms have been
reported as engaging in the ”rush-sale” or "pre-harvest sale" of
farm products.9

Most of these loans are made by discount at the Bank of Korea.
This is called a “rice-loan.”

The total money supply, therefore, rises sharply in the latter
half of the year, yet declines rather slowly in the first half of the
year. This is due to the timing of loan collections and the peculiar
loan practices on the part. of comrcial banks and the Agricultural
Bank. The sales of farm products to various industries and to the
Army, afi the repayments of these loans, were spread out. over the
following quarters. In addition, the lax loan policy of the Bank
of Korea made the banking system able to make new loans for non-
agricultural activities, partly on the basis of the collected loans
and in greater part on the basis of the large prior increase in bank
reserves or consequent increase in reserves due to the inflow of

cmency to the banking system. Thus, the contractionary effect on

the money supply of the liquidation of these loans was approximately

 

9Immediate causes for the ”rush-sale” or 'pre-harvestl'sale"
of farm products are unfavorable terms of trade against farmers,
heavy debts among the farm population and increasing deficits in-
curred by farming. In 1953, 39.4 per cent of small-scale, 23.5 per
cent of middle-scale, and 5.3 per cent of large-scale farmers were
reported to be in debt. Cf: Choi Ho Jin, "Nongchon Kyungjae
Jinheung Bang Bang," Jge Jeung, (Seoul: Jae Jeung Sa, April, 1955)
pp. 7-9.

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78
offset, or more than offset, by the expansionist effect exerted by
the additional loans.10

The seasonal index of bank deposits indicates some interest-
ing points. As the total money supply, especially the currency in.
circulation, increases during the harvest season, one may expect a
decline of the bank deposit circulation.

The decline of delmnd deposit velocity may occur either
because people substitute cash for deposits or because the amounts of
demand deposits are excessive in the economy. If the decline of
deposit velocity is sufficient, it*will bring a.donneerd impact on
the velocity of money in general. In this case, the additional money
supply'vdll not have an impact upon the aggregate spending directly.
The fact that the deposit velocity does not decline during the her-
vest season suggests that any additional money supply is directly
reflected upon aggregate spending in Korea. lhen the money supply
decreases, the deposit velocity also declines. This observation
strongly indicates that the seasonal behavior of the deposit velocity
is positively related to the money supply.

The price level is dependent upon the changes in monetary
stock and in velocity, Idth a given level of real output. iDeposit
money'couprisee about 35 to 55 per cent of the total money supply
in Korea. Since the seasonal fluctuation of demand deposit velocity

is greater than that of the money supply, as shown in Table 7, it is

 

mBloomfield and Jensen, op, cit," p. 40.

clear *h

iCCED‘UE

of more
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of K0:

79

clear that the seasonal fluctuation of the general price level is
accentuated by changes in deposit velocity.

B. Aggregate Behavior of the Money Supply

The concern of this chapter is to investigate the behavior
of money supply in relation to various economic conditions, in par-
ticular the actions of the Bank of Korea. A glance at Chart 1, page
14 indicates that the index of money supply has increased persistently
throughout the period of this study. It is interesting to observe,
however, that the period prior to the establishment of the Bank of
Korea, from June, 1945, to June, 1950, shows relatively greater
stability in the pattern of money supply than the period after the
establishment of the Bank. This may be so because there were special
problems, such as war and the problems associatedzwith war, in the
latter period. The former period, however, was not free from such
factors of economic instability as the dislocation of the South
Korean economy and the bisection of the country. These factors,
however, are not comparable to the Korean ear by any means.

The primary concern for the establishment of the Bank of Korea
and the enactment of various banking reform measures during the 1950's
'was to strengthen and reorient the South Korean banking system in order
to maintain monetary stability and to promote economic growth. It is,
therefore, worthwhile to compare the pattern of money supply'during
two relatively stable periods, one without the actions of the Bank
of Korea and the other with the actions of the Bank.

Though the Bank of Korea was established as the central bank

in June, 1950, the invasion of the North Korean comunists deprived

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80
the bank of the opportunity to carry out normal functions until the
end of 1953. The Bank imlemented various credit measures after the
actual war actions ceased around the early part of 1951. Econom-
ic conditions, however, were largely unstable until the end of 1953,
when fiscal and monetary policies, in agreement with the Republic of
Korea and the United States, materialized in positive forms. The
period after 1954 was characterized by various measures of the tight
money policy which aimed to maintain price stability. For this reason,
the period after 1954 is treated as the period in which the Bank of
Korea could perform normal functions of the central bank.

The period after the liberation of Korea was a chaotic one
until the end of 1946. The period after 1947 until June, 1950, there-
fore, can be treated as the period in which economic conditions were
relatively stable without the actions of the Bank of Korea.

By cowering the behavior of money supply in these two periods,
it may be possible to draw an inference, however crude, in regard to
the performance of the Bank of Korea. The average quarterly increase
in the index of money supply is 18.6 for the former period and 28.97
for the latter period. This imlies that the absolute amount of money
supply for the latter period was greater than the former period. This
would have been acceptable if the South Korean economy could produce
the equivalent amount of real output, assuming there was not some
deficiency in the beginning. In view of the fact that the price
level has been persistently rising since 1945, which imlies that
money supply has been excessive in the former period, it is clear

that the greater amount of money supply was inappropriate in the

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er-.

81
latter period.

It is interesting to note that the standard deviation of the
average quarterly increase in money supply is 23.75 in the former
period and 35.62 in the latter period. This indicates that the pattern
of money supply for the latter period has been in greater fluctuation
than in the former period, despite the very rigorous and extensive
measures of credit control.

This mdght have been so because economic conditions in the
latter period were in greater fluctuation than in the former period.
Rigorous attempts for economic reconstruction and deveIOpment in the
latter period, absent in the former period, could be mentioned as
one of the obvious differences between the two periods.

This difference in economic conditions between the two periods
makes it impossible to make any conclusive inference regardingthe
performance of the Bank of Korea. It should be mentioned, however,
that both periods were characterized by similar problems, although
rigorous attemts for economic reconstruction were absent in the
formwr period, with the exception of the last two years. The common
problem.is that government and businesses in both periods demanded
more bank funds.

The above discussion suggests that, with important price
increased in the period demonstrated in Chapter VI, the Bank of
Korea not only failed to maintain price stability but probably was
an agent, directly and indirectly, of price instability.

C. The Post-liberation Period

lhen seasonal behavior and aggregate behavior of money supply,

m
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meta

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Ci‘ize:

82
analyzed in previous sections, are viewed together, money supply tends
to take a step-like form with a persistent tendency toward an upward
movement. 'Our concern now is turned to the study of the behavior of
money supply, for several periods.

The rate of increase in the money supply in 1946 (129.43
per cent) is the highest one with the exception of the Korean War
period. As explained in the previous chapter, the period after the
liberation was an utterly chaotic one. This was reflected in terms
of a rapid increase in money supply.

During the four-week period from the day of liberation to
the time when sou measure of stability was established by the
arrival of occupational forces in September, 1945, notes for 3,700
million won, about. 66 per cent of the total issued in 1945, were
issued by the Bank of Chosen, which was still under Japanese control.
The notes were issued to clear the unpaid debts of the Japanese
citizens for repatriation.

The bank's notes were circulated not only in North Korea,
but. also in Manchuria and China before liberation. After the
liberation these notes became concentrated in South Korea. Citizens
and refugees from Manchuria and North Korea fled to South Korea with
cash in hand. The North Korean government dumped the Bank's notes in
South Korea in order to meet their expenditures for the propagation
of Commism and to cause a disturbance in South Korea. The notes
01" the Bank of Chosen were replaced by Red currency as soon as the

Red Army took over North Korea. Strong measures to prevent. the

83

TABLE 8

FACTORS AFFECTING MDNEY SUPPLY
(In Million Hwan)

 

 

(l) (2)
E l C 1.! I E 11' C 1
Net
Government National
Percentage Borrowing* Counterpart Bonds held
aney Change at Bank Funds in Banking
Supply C%) of Korea Deposits System

1945 3

6

9 105.08 .85

12 118.28 12.9 .81
1946 3 127.88 7.9 9.55

6 147.01 15.0 15.75

9 187.53 2.0 31.68

12 271.94 45.0 60.48
1947 3 287.65 5.8 74.36 .75

6 312.87 10.2 121.84 11.15

9 362.38 14.4 138.02 28.29

12 536.47 48.0 169.10 43.91
1948 3 539.92 .63 181.06 48.34

6 573.22 6.1 226.64 47.40

9 632.55 10.4 262.30 58.97

 

Sources: For 1945-1950, from i th ta ' t'ca Rev' w
(Seoul: Bank of Korea, March, 1951). For 1951-1960, fromylhg

Economic Annual, 1955, 1956, 1257, 1958, ggsg, and 1260 (Seoul:
The Bank of Korea).

*Borrowings by the Government minus Government deposits
including deposits representing proceeds from the sales of aid
supplies, which are shown in Counterpart Funds Deposits, an un-
numbered column.

 

Debs

 

84

TABLE 8 Continued

 

 

 

_____L§; (4L (5)
Loans to Government Agencies &
Local governments Government
Industrial By'Bank By other Loan Funds
Finance** of Korea banks to Banking
.EflfllflflflflflflLs Institutions _Iotal
1.67 2.52
2.32 3.13
1.63 11.18
1.25 17.00
6.79 38.47
40.43 100.91
35.26 110.37
3.42 125.26
7.39 145.41
7. 54 176. 64
8.98 190.04
19.61 246.25
17.47 279.77
24.18 120.91 431.41

**Industria1 Finance Debentures were issued by the Korean

Reconstruction.Bank with government guarantee.

85

TABLE 8 Continued

 

 

 

 

W16) (7) L81 (9 )
rBank Credits to Erivate Sectors
Loans to Private Sectors ‘_ Saving and
By Bank of Korea By other banks Time Deposits Total

8.00 26.06 34.06
8.75 29.01 37.76
9.15 32.52 41.67
10.22 38.71 48.93
10.99 54.11 65.11
11.26 68.57 79.83
12.90 72.13 85.03
12.98 84.22 97.20
12.58 109.35 121.93
12.62 255.20 267.82
13.02 240.52 253.54
13.49 232.70 246.19
16.97 223.90 240.87
18.21 201.69 219.90

wu-

i.ee r.

.'|Ie O

 

86

TABLE 8 Continued

(101 (11) £21 (13)
" Foreign Sector
Bank of Korea Deposits of
Purchase ‘ Foreign
of F.E. Organizations Total Others

 

68.50
77.39

75.02
81.08
83.96
91.26

92.25
90.41
95.04
92.01

96.34
80.78
111.91
85.40

87

TABLE 8 Continued

 

 

 

(1L (2)
Bank Credit to Public Sectors
Net
Government National
Percentage Borrowing* Counterpart Bonds held
Money Change at Bank Funds in Banking

Supply L%) of Korea Deposits, System
1949 3 777.26 5.5 305.67 101.07
6 818.36 5.3 330.48 165.94
9 1,087.44 32.9 375.80 316.65
12 1,276.18 17.3 387.55 443.55
1950 3 1,193.43 - 6.8 217.71 209.50
6 1,222.40 4.9 206.30 255.77
9 1,463.70 22.1 467.17 266.33
12 2,905.62 90.6 2,033.39 219.05

1951 3 4,116.00 46.1 3,230.00 885.00 34

6 5,125.00 25.6 3,952.00 -1,012.00 93

9 5,966.00 19.6 4,441.00 1,100.00 96

12 7,304.00 23.1 4,306.00 2,163.00 94

1952 3 8,224.00 15.2 4,856.00 2,202.00 91

6 9,378.00 15.5 4,974.00 2,754.00 122

9 10,822.00 16.0 3,997.00 197

12 14,325.00 29.6 5,958.00 47.00 239

 

Elli

1‘

 

88

TABLE 8 Continued

(3) 14)

 

Loans +0 Government Agencies &

 

 

 

Local Governmen+s Government
Industrial By Bank By other Loan Funds
Finance of Korea banks +0 Banking
Deunflggs Ingsrjifi'm ions Tfll
15.68 127.93 449.28
26.53 96.55 453.56
54.96 133.91 564.67
255.86 145.37 788.78
263.60 115.76 597.07
236.50 442.80
246.07 651.25
144.13 1,629.86
71.00 3,335.00
90.00 4,135.00
94.00 147.00 4,778.00
555.00 246.00 5,201.00
465.00 375.00 5,787.00
453.00 329.00 5,878.00
1,390.00 643.00 6,227.00
1,380.00 1,080.00 8,657.00

89

TABLE 8 Continued

 

 

 

 

(6) (7) (8) (9)
Bank Credits to Private Sectors 1.
.Loans to Private Sectors Saving and
By Bank of Korea By other banks Time Deposits Total
19.56 203.14 222.70
26.04 259.78 285.82
30.90 339.18 370.08
30.42 351.73 382.15
44.10 395.10 439.20
586.35 586.35
601.10 601.10
664.69 664.69
63.00 43.00 20.00
93.00 67.00 26.00
143.00 1,294.00 92.00 1,345.00
267.00 2,002.00 127.00 2,142.00
197.00 2,096.00 218.00 2,075.00
205.00 3,081.00 275.00 3,011.00
177.00 4,356.00 298.00 4,235.00
229.00 5,411.00 273.00 5,367.00

TABLE 8 Continued

 

 

 

(1o) (11) (12) (13)
Foreign Sector
Bank of Korea Deposits of
Purchase Foreign
of F.E. Organizations Total Others

105.28

78.98

152.69

105.23

157.16

193.25

149.36

63.44

17 124 - 107 868.00

17 133 - 106 980.00

17 189 - 172 15.00

71 94 - 23 - 16.00

216 53 + 163 199.00
157 12 + 145 344.00
203 7 + 196 164.00
122 83 + 39 262.00

 

91

TABLE 8 Continued

 

 

 

(11 (2)
__ Bank Credit to Public Sectors
Net
Government National
Percentage Borrowing* Counterpart Bonds held
Money Change at Bank Funds in Banking
Suoolv 1%) of Korea Deposits ,Svstem
1953 3 13,770 -12.0 6,091 127 476
6 18,224 32.3 6,451 155 723
9 25,409 39.4 9,075 170 767
12 30,316 19.4 11,490 173 770
1954 3 36,296 19.7 9,738 5,887
6 45,783 26.2 22,238 1,262 7,813
9 50,238 9.7 23,409 13,124 8,231
12 58,079 15.6 31,135 16,107 8,340
1955 3 58,142 .1 27,003 15,517 9,900
6 65,062 11.9 25,952 20,172 11,118
9 75,586 16.2 40,271 7,904 18,805
12 93,523 23.7 52,731 14,198 19,568
1956 3 90,144 3.6 44,310 28,236 21,748
6 99,011 9.8 27,713 55,234 22,376
9 103,971 5.0 15,872 49,974 28,629
11 {#631419 j-g‘fi-O £fi,c~“ ?‘i.?33

 

 

 

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t..|l||l: l3. 1' 7 till!
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92

TABLE 8 Continued

 

 

 

(311 (4) ’_ 51
Industrial Loans to Government Agencies 8
Finance** ____ Local Governments Government
Debentures By Bank By other Loan Funds***

held by of Korea banks to Banking

Bank of Korea Institutions Total

1.487 1,300 A 9,454

1,627 1,608 A. 10,409

1,627 1,658 N.A. 13,127

1,847 2,858 N.A. 16,965

1,227 3,303 N.A. 20,155

1,552 92 N.A. 31,695

555 245 N.A. 32,440

545 - 440 234 40,457

1,600 356 N.A. 38,860

2,000 700 315 N.A. 40,086

2,000 700 551 N.A. 62,327

2,000 700 825 500 75,824

2,000 500 725 N.A. 69,283

2,000 746 N.A. 52,835

4,000 929 N.A. 49,430

4,000 1,529 534 72,262

 

***Government Loan Funds to banking institutions is treated
as the declining factor for money supply in the public section.
These loans are included in Column 7, Loans to private sector by
other banks. To the extent, credit expansion to the private sector
is overstated.

.
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TABLE 8 Continued

 

 

_F _Lé) (7) (8) (9)
Bank Credits to Private Sectors
Loans to Private Sectors Saving and

 

 

By Bank of Korea By other banks Time Deposits Total
291 6,606 2,091 4,806
332 9,807 2,074 8,065
529 13,185 2,231 11,483
732 15,277 2,385 13,624
878 14,703 2,629 12,952
655 16,231 2,997 13,889

1,140 18,648 3,478 16,310
425 22,031 3,860 18,596
870 25,306 4,851 21,325

1,335 33,159 5,167 29,327

1,238 35,570 7,770 29,038
660 37,117 6,990 30,787
544 41,866 13,068 29,342
376 59,177 13,608 45,945
348 72,769 15,546 57,571
377 70,627 14,222 56,792

.v

 

 

93

TABLE 8 Continued

 

 

 

(10) 3(11) (1211 (1311
Foreign Sector
Bank of Korea Deposits of
Purchase Foreign
of F.E. Organizations Total Others
397 179 218 - 688
563 312 261 - 501
994 247 747 102
1,264 383 881 - 1,154
2,108 1,029 1,079 2,110
1,799 1,007 792 - 193
1,631 359 1,272 216
1,533 1,391 142 - 1,116
1,402 2,865 - 1,463 - 580
6,207 10,863 - 4,656 305
3,694 8,903 - 5,215 -10,565
2,234 12,631 -10,397 - 2,691
2,391 11,426 - 9,035 554
10,940 6,611 4,329 - 4,098
12,646 11,904 742 - 3,772

13,898 14,246 - 348 - 7,781

 

 

 

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TABLE 8 Continued

 

 

 

(1) (2)
Bank Credit to Public Sectors
Net
Government National
Percentage Borrowing* Counterpart Bonds held
Money Change at Bank Funds in Banking
Supply 1251 of Korea Deposits SvstenL
1957 3 120,239 - .6 14,554 .100,015 50,240
6 119,288 - .8 4,078 108,091 50,081
9 125,049 4.8 8,314 129,373 53,546
12 145,184 16.1 - 4,172 114,332 64,345
1958 3 147,056 1.3 -18,819 134,127 64,054
6 149,141 1.4 - 7,690 133,696 63,385
9 165,781 11.2 3,001 120,395 62,934
12 192,553 16.2 24,035 98,930 58,000
1959 3 210,710 9.4 34,148 108,721 57,667
6 206,703 - 2.0 44,419 78,526 57,675
9 203,714 - 1.4 35,915 76,820 57,600
12 209,900 3.0 54,695 63,707 57,372
1960 3 211,072 .6 52,704 37,571 55,890
6 206,898 - 2.0 41,806 39,070 56,120
9 199,278 - 3.7 21,608 82,953 56,786
12 219,077 10.0 20,693 86,333 56,531

1,3,8

0»

 

 

 

TABLE 8 Continued

(3) (4L (5)

Industrial Loans to Government Agencies 8

 

 

Finance** Local Governments Government

Debentures By Bank By other Loan Funds***
held by of Korea banks to Banking

Bank of Korea Institutions Total,
4,000 1,576 N.A. 70,370
4,000 1,334 N.A. 59,493
4,000 2,293 N.A. 68,153
8,000 1,802 10,771 69,971
8,000 1,694 11,128 43,801
8,000 1,608 12,157 53,146
12,000 2,342 44,767 35,510
16,000 2,117 63,930 36,222
15,950 1,403 74,265 34,903
15,950 1,228 74,934 44,338
15,950 1,059 78,048 32,476
15,950 2,811 77,675 53,153
16,400 2,932 80,605 51,091
16,400 2,878 84,365 36,609
16,400 3,383 89,097 12,800
16,400 3,186 90,734 96,800

 

———. -

 

 

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971

TABLE 8 Continued

(6) (71 (8) (9)
Bank Credits to Private Sectors
Loans to_Priyate Sectors;w Saving and

 

By Bank of Korea By other banks Time Deposits Total
252 68,752 12,196 56,808
195 79,071 12,691 66,575
160 92,152 14,946 77,366
179 107,479 15,124 92,534
112 109,610 16,141 93,581

87 110,025 17,414 92,698
87 133,787 19,495 114,379
127 156,594 19,161 137,560
87 169,986 27,392 142,681
84 173,088 33,448 139,724
84 175,092 42,537 132,639
84 179,775 54,908 124,951
84 202,582 69,705 132,961
84 201,646 62,945 138,785
84 210,276 54,428 155,932
84 239,961 57,006 183,039

98

TABLE 8 Continued

 

 

 

_ 110)_ (11) (12) 113)
Egreiqn_Sect0r
Bank of Korea Deposits of

Purchase Foreign

of F.E. Organizations Total Others
17,354 17,863 - 509 - 6,430
21,033 25,736 - 4,703 - 2,077
19,688 32,359 -12,671 - 7,799
25,972 21,251 4,721 -22,042
24,448 19,922 4,526 5,148
28,384 32,068 - 3,684 6,981
32,703 24,749 7,954 7,938
39,147 19,265 19,882 - 1,111
41,934 14,570 27,364 5,762
38,859 20,463 118,396 4,245
37,992 11,310 26,682 11,917
36,968 14,416 25,552 9,244
31,624 20,222 11,402 15,618
34,373 16,191 18,182 13,322
36,778 14,067 22,711 7,835
44,290 10,885 33,405 - 7,213

 

 

1. .L#

.41..

 

 

99
dumping activities were implemented in South Korea. However, evidence
suggests that the South Korean economy absorbed a significant amount
of the dumped currencies.11

Except for the third quarter in which money supply rose only
2 per cent, the rate of increase in the money supply was very high in
1946; 8 per cent in the first quarter, 15 per cent in the second
quarter, and 45 per cent in the fourth quarter. The need for eXpendi-
tures in defense and security, plus the inefficient management of
government agencies and vest industries on one hand and declining
tax revenue on the other, called for an enormous overdraft by the
government from the Bank of Chosen (now the Bank of Korea) and credits
from other banking systems. The 45 per cent increase of the money
supply in the fourth quarter, which consisted of credit for about 62
million hwan to the public sector and 14 million hwan to the private
sector, was due to the peculiar seasonal behavior of money supply
explained in the previous section.

The rate of increase slowed down during 1947. Yet, the in-
creasing amount of overdrafts and borrowings by the military govern-
ment from the Bank persisted throughout the period. In the third and
fourth quarters of 1947 credit to the private sector increased rather
sharply; This is partly due to the fact that substantial increases
in‘Bank of Chosen loans to commercial banks were made during this

period, and partly due to the fact that the increased credit to the

 

11Yoo Jin Soon, Economigs (Seoul: Korean Economic Associ-
ation, September, 1953), p. 140.

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100
public sector in the previous periodpovided a further basis of
credit expansion by conercial banks with the increase of bank re-
serves at the Bank of Chosen.

In 1948 the money supply increased 37 per cent, a rather
slow rate compared with the previous period. The establishment of
the Republic of Korea on June 12 might have promoted stability. The
new government's spending policy, however, resulted in a large in-
crease of the money supply, especially in the third quarter of 1949.

The major cause of the decrease of money supply was the
proceeds of the sales of aid goods, which absorbed the currency in
the open market. Until the beginning of 1947, collection of the
proceeds of aid goods sales had been lax, and the proceeds were
scattered in various financial institutions. With the reception of
the ECA aid goods, however, the proceeds were collected and deposited
at the Bank of Chosen. Counterpart Fund Deposits of Table 8 shows
the increasing proceeds from aid goods.

Despite the increasing collection of proceeds from the sale
of aid goods, the money supply rose sharply in 1949 as compared to
1948. This rapid increase was mainly due to increased credit expan-
sion from the banking system to the public sector, which includes
government, government agencies, and vested properties. lhile the
causes for money expansion under the military government were
confined to relief and defense needs, the Korean government seemd
to have been more aggressive about economic reconstruction. In

addition, the Korean government had to pay military expenditures

 

I.

------

19

C9

+1:

it

101
which were previously paid by U. S. Army apprOpriations. With the
arrival of the ECA aid goods, economic activities were brisk from
1949 until the Korean War.

Credit controls, mainly the prior approval of loans beyond
certain amounts by the government have been implemented since 1946,
though their administration was very lax and ineffective. In the
meantime, a positive step toward credit control was initiated from
the end of 1949. The money supply declined 6.8 per cent in the
first quarter of 1950. In 'March, 1950, the Fifteen Points of
Stabilization Policy was initiated with a joint agreement between
the ECA authorities and the Korean government. The policy was aimed
at. tightening credit expansion, by tightening the government budget
and credit expansion and increasing the government revenues by tax
reform and the sale of vested preperties. In the second quarter of
1950 money supply rose by the reasonable rate of 4.9 per cent.

D. The Korean lar Period

lith the invasion of South Korea by the North Korean
Con-mists, the money supply increased sharply; 123 per cent in
the second half of 1950. Needless to say, the expansion of bank
credit to the public sectors was the major cause of this rapid
increase of money supply. During the single 1950 fiscal year,
govertnent budgeting changed seven times to meet the urgent needs
of defense expenditures. On the other hand, production, mining,
power facilities, and housing and transportation facilities ceased

to operate and were damaged by war. As a result, tax revenues

dec
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w

 

ICC

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102
declined to almost nothing.

Advances to the United Nation Forces12 necessary to finance
the local-currency requirements by the United Nation Forces were
additional causes for credit expansion to the public sector. During
this period expansion of the money supply was made exclusively in
terms of Bank of Chosen notes.

During the chaotic period of June 1950 to February of 1951,
the South Korean government retreated from the capital city of Seoul,
recaptured it for a short time, and was forced to retreat again. Net
increase of note issues, government overdraft and the advance to the
United Nation Forces during this period are shown in Table 9.

TABLE 9

NOTE ISSUES, GOVERNMENT oveanam, no DVAMIES IO

sums) NATION FCRCES, JUNE, 1950 -‘-- FEBRUARY, 1951.13
In Million Hwan

( A ) ( B ) ( C )
Net Increase Government Advances to
of Note Issue Overdraft United Nation B/A C/A

Period of the 1st

 

Retreat 390 213 62 54% 16%
Period of Capturing
the Capital City 1,344 1,082 486 80% 36%
Period of the 2nd
Retreat 863 403 _2_J=2 fl egg
Total 2,597 1,698 767 65% 30%

 

12’On June 28, 1950, an agreement was made between the United
States and Korean Govern-ants regarding the supply of local currency
and credit to the United Nation Military Authority for its local use.

l"‘a‘Source: The Bank of Korea, Monthly Stgtist icg; Review
(flarch, 1951), p. 125.

103

A somewhat minor reason for the expansion of money supply was
the withdrawal of time deposits. Before and after the war the central
bank and other banking institutions were faced with the rush-withdrawal
of deposits, though restrictions, for example a maximum amount of
withdrawals, succeeded in limiting the extent of the withdrawal of
deposits. To meet the situation, the central bank extended the
credit tothe banking system to about 241 million hwan. The ratio
of deposits to currency outstanding became unusually low; conse-
quently, the banking system was completely unable to operate the
banking functions except for feeding the notes to the public. There-
fore, the extent of the withdrawals of time and saving deposits con-
tributed to the net expansion of money supply in this period.

After the frustrating experiences of the first retreat, the
reoccupying of the capital city and the second retreat, it was recog-
nized that the government must settle dovm in Pusan temporarily. That
is, it was anticipated that the war was not likely to be a short one.

Because of this anticipation and other natural reactions
regarding heavy: government expenditures, an unusually tight fiscal
policy, "Pack's TightFiscal Policy,” was implemented. (Pack is the
nuns of the Prime Minister). As a result, government borrowing from
the central bank due to budget deficits was somewhat reduced. At
the same time, increasing amounts of collections from sales of aid
goods, 2,163 million hwan at the end of 1951, provided a strong
force for contracting money supply.

Despite the tight fiscal policy and the increased collections

['IvDIVE,

104

from sales of aid goods, money supply continued to rise at a faster
rate in 1951 than in the previous year. Money supply rose an
average of 43 per cent in each quarter, a total of 170 per cent
‘within 1951. The advances to the United Nations forces brought about
inflationary pressures. Because of disagreement about a foreign
exchange rate between the Korean government and the United States,
the military authority refused to make dollar payments for their
loans at the Bank of Korea; 3,623 million hwanvce accmulated by
the end of 1951, thus contributing a strong inflationary pressure.

In addition, the expansion of credit to the private sector
added fuel to an inflationary spiral in the latter half of 1951. A
rapid increase in bank credit to the private sector was observed, as
shown by Celuam 9, Table 8. Loans increased from 26 million in the
second quarter to 1,345 million in the third quarter and 2,142
million in the fourth quarter. Obviously, there was no coordina-
tion of policy between the Korean and the United States governments.
For fromtthe second quarter on, an attempt was made to provide credit
to the private sector in order to facilitate economic activities, on
the assumption that the repayments of advances to United Nation
forces made it feasible. The enormous expansion of credit to private
sector was made possible by the credits from the central bank to the
commercial banks, (707 mdllion hwan in 1951). ‘During 1951 fiscal
year 1,231 million hwan (or 123.1 billion won in old currency) of
credit expansion was set as the maximum. ‘Yet, the actual expansion
of credit was 1,927 million hwan. The lax loan ceiling policy of

the central bankmust have been the cause of this enormous expansion.

 

H‘

 

 

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105

However, the comercial banks also gained the increased basis for
secondary expansion by the increase of deposits which was due to the
conversion of notes into deposits by the public and the net increase
of the assets of the central bank.

Though a 99 per cent increase in money supply in 1952 is
much too high, the rate of increase in money supply in 1952 showed
a substantial decline compared with that of 1951. 'Pack's Fiscal
Policy,” became tighter in 1952 than in 1951, showing the decline of
694 million hwan government borrowing from the central bank from
the previous year's level. The increased collections from sales
of aid goods in the first two quarters helped contract money supply
greatly. However, during the last two quarters the collections
from sales of aid goods were virtually nothing, due to the stale-
mate in negotiations between the United States and the Korean
governments. The advances to the United Nation forces continued
to expand. Some of the accuulated advances was repaid in terms
of dollars; thus, the sales of these dollars in the last quarter of
the year contracted money supply by 217“ million hwan.

E. The Currency Reform and the Period of Tight Money Policies

A peculiar year was 1953 in the sense that stabilization
policies expressed by the government, aimed at the contraction of the
money supply, had the consequence of turning out to be expansionary.

Iith the initiation of the positive economic aid of the ECA,15

 

1"the Bank of Korea, Economic Annual, 1955 (Seoul: Bank of
Korea, 1955), p. 1-35.

- 1"’Before 1953, a variety of Aid Organizations acted independ-
ently of each other. The arrival of UNION, and the establishment of
the Office of Economic Coordinator, which was composed of representa-
tives of F.O.A., U.S.A. and the Korean government, improved the aid
POIiCiOCe

r 1

r;

 

 

106

an effort to stabilize the economy by preventing an excess supply of
money was established before the Korean War. As was explained, the
Fifteen Points of Stabilization Policy was established in March, 1950.

The Bank of Korea opened business as the central bank in June,
1950. The Act of the Bank of Korea was designed to set up in inde-
pendent monetary authority, and the Bank hoped to eliminate or prevent
the bank credit expansions which were often made in connection with
political pressures.

These policies, however, were interrupted by the Korean Var.
After the truce, hopes for economic reconstruction were brightened
by the arrival of the UNKRA and the Foreign Operations Agency, and
the efforts of the policies were renewed with added enthusiasm.

The first one was the currency reform of February, 1953.
One hwan of new currency was exchanged for 100 won of old currency,
up to 500 hwan for each citizen. The law also stipulated certain
types of deposit accounts to be blocked and provided a series of
rates by which the old currency could be exchanged with the new one.
The impact of inflation was everywhere. Traders and middle-men
generally fared better than the rest of the population. On the
other hand, most productive enterprises had been extremely hard
pressed. Consequently, the vast amount of funds were channeled into
non-investment activities. The funds concentrated in these non-
investment activities, in turn, raised the interest rate in the open
market, thus creating undesirable pressures upon investment activ-

it ies.

The designers of currency reform, therefore, planned to

107
absorb about three billion Iran, and hoped to re-channel these funds
into investment activities. On what basis this amount of repudiation
was esti-ted is not known.
At the end of February, after the reform, total money supply
was reduced from 15,799 million hwan to 14,990 million hwan, a re-

16 A careful study-of the sta-

duction of approximately 5 per cent.
tistics, however, shows that notes outstanding declined from 10,024
million lavan to 6,890 million hwan, 31.3 per cent; and private
currency deposits from 2,128 million hwan to 1,384 million hwan, 36
per cent. That is, the money supply available to the private sector
was reduced by 3,878 million hwan, which was greater than what the
government planned to absorb. On the other hand:, other deposits of
government agencies and, some private persons increased from 3,359
million Iran to 6,467 million Man. This increase reflects largely
the blockedaccounts because each citizen was entitled to exchange up
to 500 hwan, with the balance after the payments of overdue taxes
being deposited with banking institutions. The increase of these
‘ deposits, therefore, did not exercise any effect on aggregate demand.
This observation indicates that the money supply was deficient
i-ediately after the reform temorarily. On February 25, the Cur-
rency Reform Bill was before the Congress to be ratified. The series
of exchange rate for the blocked accounts was reduced by the Congress,

presumably because of the scream of scarcity among the public and

because of the conservative elements in the Congress. Consequently,

A‘ A— _

16The Bank of Korea, Eggnggc Annual, 1955, pp. 2-18.

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108
the money supply tended to increase from lhrch onward, after a
temporary slacking in February.

Since then, the Congress has been blamed for continuing
inflation.l7 However, the government sector, as can be seen in
the over-ambitious plan of government expenditures in 1953.

The original budget for the 1953 fiscal year estimated
138,607 million hwan of expenditures, incurring 42,930 mdllion
hwan of deficits which were to be financed from the central bank
credits, as shown by Table 10. Bond issues worth 2,000 million
bran were sold to the banking system, thus providing an additional
increase in money supply.

Compared with the executed budget of 1952, the 1953 budget
was too large. Huge increases in defense and reconstruction
expenditures were the major causes for the budget increase. It
must be noted that revenues of 24,488 million hwan were based on
the anticipated large increase of American economic aid. It can
be safely concluded, indeed, that 1953 budgetary and fiscal policy
anticipated an increased money supply, rather than seeking to
contract it.

"The Republic of Korea experienced very frustrating situa-
tions after the truce agreement. As to the expected quick economic
aid on the part of the United States, almost four months‘were spent

in smoky conference rooms by representatives of the Korean and

17m MI. W (Seoul: 8:11:
Young Sa, 1954), pp. 137-185. Also see Us l..§ggng|i§_§g;xgx_g£
Asia lag the Pg; 533;. 1254. p. 92.

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109
and United States Governments because of disagreement about several
points of economic policy, especially the foreign exchange rate.
Stalemates at the conferences caused the delay of the arrival of aid
goods which, in turn, provided pressure on the government budget.
Also, the amount of aid was settled at about 60 per cent of the
amount the Korean government expected to receive.

The government budget was modified two or three times to
make it more realistic in this changed situation. Therefore, the
major burden of the government deficit, though it was reduced some-
what after revisions of the budget, was placed on the central bank.
To counteract this expansionary situation, the advances to the U.N.
forces were repaid to the government. The government sold these
so-called U.N. "Military Dollars” in the Open-market, absorbing
about 20,499 million hwan in 1953. Together with this counteracting
factor, the collection of the proceeds from the sale of aid goods
aapunted to 7,760 million hwan.

The year 1954 marked a fresh start for economic reconstruc-
tion. After a series of conflicts between the United States and
the Korean government, an agreement concerning "Financial Stability
and Economic Reconstruction” was reached in December, 1953. The
Office of the Combined Economic Board set up the plan for sources
and uses of funds for each quarter. However, ambitious government
Projects for reconstruction*were launched seemingly independently of
the»CEB. Some call 1954 the positive stage of economic reconstruc-
tion. A phenomenal change was the increase of government overdrafts

during the second quarter of 1954, and a net increase of five billion

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111
hwan in bonds held by the banking institutions in the first quarter and
a continuous increase in bonds held by the banking system throughout
the year.

Due to the nature of the reconstruction projects, funds were
primarily allocated for capital investment. As a long-term lending
bank, the Korean Reconstruction Bank was set up under the control of
the Ministry of Finance. Credit expansion to the private sector by
the commercial banks increased substantially in 1954. The previous
loan ceiling set up on commercial banks was abolished. This pro-
vision enabled the commercial banks to make more loans. The rediscount
ceiling at the Bank of Korea was adOpted in accordance with the CEB
plan. However relatively easy advances from the Bank of Korea to
commercial banks also provided an additional stimulant for credit
expansion to the private sector. The collections from the sales of
aid goods showed an increase in the second quarter of 1954. Despite
the factors which contributed greatly to the contraction of the
money supply, the money supply increased 92 per cent in 1954.

This inflationary situation invited a sharp reaction from the
United States representatives of the CEB, creating a political un-
certainty which caused a sharp increase in the general price level.
The foreign exchange rate was raised from 180 hwan to 500 hwan per
dollar in 1955, as suggested by the United States representatives.

To maintain the revised exchange rate, tight money policies were
instituted by the government. Since the first quarter of 1955,
government spending, thus deficits, have stayed about the same.

Heavy spending was inevitable because of a large military

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112
expenditure and the previous cosmitments of the government for re-
construction projects. The expansion of credit to the private sector
by the comercial banks rose faster due to the repeal of the loan-
ceiling policy to the banks. The rate of increase of the money -*
supply, therefore, was relatively high in 1955.

The money supply was reasonably stable in 1956. The govern-
ment overdrafts showed some declining tendency yet the government
deficit in 1956 was greater than in 1955. Credit to the private
sector expanded at a faster rate. Total expansion of credit made
by the co-ercial banks in 1956 was 27 billion hwan, about twice
that of 1955. A major contracting factor of money supply was the
increased collections from the sale of aid goods. These increased
collections .de the government overdrafts decline and enabled the
goverment to repay some of its loans to the Bank of Korea in the
third quarter of 1956.

Increased arrivals of aid goods in 1957 and 1958 contributed
greatly to the contraction of money supply. In 1957 the government
implemented a strong "Financial Stabilization Program.” This program
out in half the credit expansion to the private sector made by the
co-ercial banks. let loans to the government from the Bank of Korea
declined sharply. In the third quarter of 1958, the government
repaid many large loans made at the Bank of Korea. In the fourth
quarter of 1958, the tendency toward declining aid brought pressures
upon the government, which was evident in an increasing government

overdraft. However, a reasonably stable money supply was maintained

until the third quarter of 1960.

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CHAPTER VI

THE MOVEMENT OF THE PRICE LEVEL, 1945 - 1960

' T ob m o the Pri e e

Several price indices published by the Bank of Korea are
available in Korea: the Seoul Hholesale Price Index, the Rational
‘lholesale Price Index, the Index of Cost of Living, Retail Price
Index, Export Price Index, Import Price Index and the Index of
Hanufacturing Workers' Earnings. The International Monetary Fund
also publishes similar types of indices.

With the exception of the Seoul Wholesale Price Index, how-
ever, there is no index which covers the entire period of this study
from 1945 to 1960. For exanple, the Seoul and National Retail Price
Indices‘were discontinued in 1957 and were replaced by the Index of
Cost of Living with different weights and different sample classi-
fications. The Export and Import Price Indices were computed only
after 1957.

A possible alternative method of indicating price changes
would be to use the GNP implicit deflator as the index of the
general price level. This involvbs two difficult problems. The GNP
data have been revised two or three times as the statistical tech-
niques improved and the data are available only after 1953.

Because of these many problems the Seoul lholesale Price
Index is used as a representative index. This index has continuity

and is available for the period with which this study deals. The

113

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114

Seoul Wholesale Price Index published after 1949 by the Bank of Korea,
is based on the Weighted Aggregative Method or Laspeyres Method. The
index prior to 1949 was computed by the simple average method. The
index based on the simple average method was recomputed to 1945 by
the Laspeyres Ilethod in order to maintain the consistency of the index.

This index, like any other price index, attempts to reflect
the changes in prices of major commodities. It does this by assuming
that the quantity and quality of the "basket" items included in the
couodities do not change from year to year. The price index problem
has its inherent difficulties as is commonly known. The Laspeyres
lethod has a tendency toward an upward bias. The number of items
included in this index and the respective weights of the index are

 

 

as follows:1
Classification Number of Weights
of 99mm,“ # i thm;
Grains 10 42.49
Foodstuffs 4 5.23
Textiles (Raw Materials) 4 9.83
Textile Products 6 7.43
Building Materials 8 2.71
Fertilizers 3 2.10
Fuels 4 5.58
Miscellaneous ll 24,52
Total 50 99.96

There are further important qualifications regarding the
accuracy and general representative character of the Seoul Wholesale
Price Index:

A. This index uses constant weights taken from the base year,

1947. Buying habits have changed violently since the Korean War.

1The Bank of Korea, Outline of Price; (Seoul: Bank of Korea
1961), pp. 15-18.

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115

B. A great portion of raw materials was devoted to the pro-
duction of war goods during the Korean War period and some commodities
were not produced during the war period. Thus the weights in the
composition of the wholesale price index are not equally valid through-
out the period.

C. The index does not reflect the so-called 'G.I. Markets,”
which have grown rapidly since 1945; that is, an important segment of
transactions was excluded from.the price index.

D. lany commodities were distributed on a non-price basis
during and after the‘war.

E. The prices of some commodities included in this index are
controlled by the Korean government.

For these reasons, the Seoul Wholesale Price Index appears
to be an inaccurate and unreliable index. Furthermore, the Seoul
Wholesale Price Index reflects changes in wholesale prices in Seoul
which are not the same as price changes in the Korean economy as a
whole. This point is described in Chapter B, Appendix. Therefore,
the index of average denomination of currency is computed as an alter-
native and, hapefully, as a better measure.
WW

Professor John J. Klein uses the average denomination of
currency as the price index in his study of "German loney and Price,

1932-1944.“2 This portion of this study is based on Klein's prece-

‘ _.—_ —_-_ __¥_—_¥ - —‘_.—
“w— V———_ ——

2m»: J. Klein, "cor-n mum and Price, 1932-1944; F
Chicago:

Wm. od- Iilton Fried-In
University of Chicago Press, 1956), pp. 3-21.

 

 

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116
dent. After a review of Klein's exposition, an attempt is made to
reformulate Klein's contention in the light of the Korean situation.
In particular, the actions of the Bank of Korea are introduced in
our exposition.

Klein primarily observed changes in the denominational dis-
tribution of currency or the composition of the notes held by the
public as the function of price changes. ”If price becomes higher,
then, since one has to pay more for his goods, he prefers to carry
larger denominations of money with him for his purchases.'3 Changes
in the average denomination, defined as the total value of notes
divided by the number outstanding, therefore measure changes in the
price level.

A crucial factor in determining the average denomination is
the public desire to hold money of various denominations. Factors
which affect the demand for money can explain the public holding
of money in various denominations. There are many factors which
affect the demand for money.4 In this study, a siuplified version
of the demand for money*will be used in order to concentrate on the
main idea of the subject. For our study, therefore, changes in
the general price level, real income and expectations of velocity
are sufficient. Based on this simplified version of the quantity

theory, we will attempt to establish several relationships. The

— t v—‘f

3Klein, Ibid., p. 142.

4For a sOphisticated explanation of the demand for money
see Milton Friedman, “The Quantity Theory of Money - A restatement.”

in Studies in the Quantity Theory of Money. ed. Nfllton Friedman

(Chicago: University of Chicago Press, 1956), pp. 3-21.

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117
first one is the relationship between the average denomination and
changes in prices. For this purpose, it is assunod that factors
other than changes in the general price level remain constant.
Changes in other factors attendant to the changes in the general
price level - changes in real income, relative prices, the real
value of cash balances and expectations - are assumed to be insig-
nificant.

Secondly, an attempt will be made to establish the relation-
ship between the average denomination and the changes in real
income. In this case, factors other than real income are assumed
to be constant.

After these two relationships are established, changes in
other factors attendant to changes in the general price level and
in real income will be considered. The assumption of constant
velocity is a reasonable one, as is shown in Chapter B, Appendix.
Therefore, this assumption is not removed throughout the analysis.
An assumption implicit in this exposition is that the total money
SUpply is solely composed of currency.

The average deggmination and changes in prices. What happens
to the average denomination of currency when prices double? Klein's
exposition will be presented first. Klein considers two situations:

(1) that the individual desires not more than the same number of
bills with a rise in prices, for example, 12, and (2) that he wants

9 Given division of notes (e.g., 1:5). If the individual initially
held his money in 10- and 50- reichsmark notes and if there were 200

reichsmarks outstanding in total value, then the situation before

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118
the price increase was that indicated in Case A:
Case A: Situation before Price Rise
50 Rm (Value of individual notes) X 2 (no. of notes) - lOO Rm
lo Rm (Value of individual notes) X 19 (no. of notes) 8 m Rm
Total 12 ' 200

, WW
Suppose denominations are continuous.5 If situation (1) is
met, then situation (2) will be met autoamtically. When prices
double, the total value of currency will be 400 reichssmrks. The
situation is represented in Case B:

Case B: Continuous Denominations after Price Doubling
100 Rm (Value of individual notes) X 2 (no. of notes) 5 200 Rs:
20 Rm (Value of individual notes) X 19 (no. of notes) 3 _2_O_Q Rm
Total 12 400

o ofC - 3

The average denomination of currency and the price level
have exactly doubled. The average denomination, in this case, is
a good index of price changes.

suppose that denominations are discrete. Assume further that
there are only lO- and 50- reich-rk notes. If situation (1) is met,

the average denomination of money will be exactly doubled, as in

*. ___ _ - A

5This means that notes are available in continuous sizes or
values so that the public can hold any size of notes it desires. If
a man desires to increase note-holding in proportion to price changes,
he can do so in this circumstance. If notes are not continuous or
discrete, tho public finds it difficult to adjust its note-holdings
in proportion to price changes.

119

Case C:

Case C: Discrete Denominations in Situation 1

50 Rm (Value of individual notes) X 7 (No. of notes) F 350 Rm
10 Rm (Value of individual notes) K_§ (No. of notes) 3 50 Rm
Total 12 400 Rm

Ibo Average Degomination of Currency - 33.3 Rm
If the 50-50 division of the monetary value of currency in

situation (2) is met, the average denomination remains the same.

50 Rm (Value of individual notes) X 4 (No, of notes) 3 200 Rm
lO Rm (Value of individual notes) x.gg (No. of notes) 3.299 Rm
Total 24 400 Rm

Ihg Average Denominatiog of Currengy - 16.7 Rm

Thus Klein concludes:

”Clearly, then, with discrete denominations, the two given
conditions are not compatible to each other. The most that
can be said is that it is likely that the individual will
hold more bills than before but not so many as to keep the
average denomination of money the same as before the rise
in the price level.'6

This means that the relationship between the change in
prices and the changes in the average denomination is undeterminable.
With a 100 per cent increase in the price level, the average
denomination'will increase less than 100 per cent, but much more than
0 per cent. This conclusion certainly casts serious doubts on the use
of the average denomination as an index of price changes. Klein, how-

ever, attests to the usefulness of the average denomination as a price

‘_ ___‘_ .

6Klein, op, git., p. 44.

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120
f
index, especially during the period repressed inflation.7

It seems that Klein did not establish a firm theoretical basis
for the index of average denomination. This is partly due to his
illustration. It seems necessary to review Klein's assumptions of
the 50-50 division of the values of currency and the discrete denom-
inations in the light of the Korean situation.

Suppose that the demand for money is only for transaction
purposes. Since the speculative demand for money in under-developed
countries is normally small anyway, it seems that this assumption can
be justified. The demand for money, then, is related to the size of
transactions an individual Cut out, assuming further that there is
no rapid change in financial institutions, payment habits, frequency
of purchases and any other factors which affect the demand for money.
The amount of money an individual holds can be expressed in terms of
a certain number of notes or a certain proportion of different notes.
In the initial period of our preceding example, the number of notes
was 12 and the total value of notes was held in a 50-50 proportion.

Suppose that the size of transactions is doubled because of
the doubling of prices. Would the individual try to maintain the
same proportion of note-holdings? The 50-50 division seems to be
unrealistic. Although an individual carries certain values of notes
and coins, it is unrealistic to assume that an individual holds a

certain proportion in his note-holdings. Notes can be exchanged at

—._—..__ — __— __ __—
——w —
—— —__.

7Klein, pp, cit., pp. 120-159. Also, ”Price-level and Money-
Denomination Movements,“ The Journal of Political Economy, LXVIII,
No. 4 (Auqust, 1960), pp. 369-378.

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121
the grocery or drug store whenever the need for change arises. Carry-
ing noteslin the minimum, desirable number seems to be essential be-

8 Therefore, we take Klein's second situ-

cause of the fear of loss.
ation, the 50-50 division of notes, out of our illustration.

The assumption that an individual tries to carry the same
number of notes before and after price changes is crucial in our
exposition. If an individual carrys the same number of notes that
he used to carry before the price changes, although this is not always
possible, the average denomination is the perfect index of price
changes. 'le can say, then, that the public adjustmmnt of note-holdings
is preportional to price changes.

fin is an animal of experience. During a period of stable
price, say for two years, he carrys daily the minimum.number of notes,
some days more and other days less. 0n the average, however, he
carries daily the same number of notes during this period of stable
prices. Suppose prices double, other things remaining constant. The
individual, then, will have to carry twice as many notes than he used
to carry in order to purchase the same amount of goods, if he does not
switch from lower to higher values of notes. It is not necessary for
any one to carry twice as many notes to purchase the same amount of
goods, especially when one can secure change as needs arise at almost
any store. Besides, it is inconvenient and also involves the fear of.

loss when one carries bulky paper notes. Re would certainly carry

—— -__—

8The behavior of banks is similar, as confirmed by an inter-
view with lilliam C. Peck, Assistant Vice-President, Michigan National
Bank, Lansing, July 15, 1962.

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122
less than twice the number of notes or the same nudaer of notes as
before by switching from lower to higher value notes.9 If one holds
the same nudier of notes before and after price changes, the index of
average denomination is the perfect index of price changes.
The public adjustment, however, may not be proportional to

price changes. If the public delays the adjustment, the average

10 It

denomination is likely to lag behind the price changes. seems

more likely that the public delays the adjustment as pointed out in
Fisher's statement:

Yet we are so accustomed in our business dealings to
consider money as the one thing stable, - to think of

a “dollar as a dollar" regardless of the passage of
time, that we reluctantly yield to this process of re-
adjustment, thus rendering it very slow and imperfect.11

Klein, in my opinion, implicitly assumes that a given structure
of denomination is based solely upon public demand. That is to say,

the distribution of notes in various denominations depends solely upon
the public desire to hold notes of certain denominations. The public

is not homogeneous by any means. Some groups, like bankers, traders

9It is crucial in the Cambridge approach to the quantity theory
that an individual attemts to maintain the real value of his cash
balance. In similar context, the fact that an individual switches
from lower to higher values of notes implies that the individual tries
to maintain the same real value of cash balance for each unit of
currency. He may desire to comand the same real resources for each
unit of currency. lie can achieve this by holding the same nufier of
notes before and after price changes.

10If the public overly adjusts, on the other hand, the average
denomination will rise more than the increase in actual prices. Over-
adjustment is possible when people expect continuous price increases,
thus switching from lower to higher denominations in excessive propor-
tion. This my be possible in a situation of extreme inflation.

“Irving Fisher. W (New York:
IICMIIII'I COe’ 1911), D. 57s

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123
and manufacturers, are very sensitive to the price changes in note-
holding behavior, while others are very insensitive. In view of the
fact that agricultural activities are predominant in the Korean
economy, there exists a great chance of delaying the adjustment of
note-holding on the part of the public.12 Therefore, the average

denomination may lag behind the actual changes in prices.

It is imortant to realize, at this point, the significance
of the action of the Bank of Korea. When the Bank issues various
denominations of notes, it considers several factors. The public
dennd for particular values, as Klein assumes, is an important
factor. However, the cost of printing and handling the bills is
also iqortant. As prices rise, the Bank tends to issue higher
values of notes, new or otherwise. This action essentially makes

the denominations more continuous.13 That is, the Bank makes differ-
ent denominations available so that the public can adjust its note-

holdings, as in Case D, for example.

“-

12See Ricks: ”considerable proportion of a comnity's mone-
tary stock is always likely to be in the hands of people who are
obliged by their relative poverty to be fairly insensitive to
changes,“ J. R. Hicks, ”Suggestion for Simlifying the Theory of
money,“ W (New York: Blakiston Co., 1951),
p. 31.- Keynesalso refers to a similar situation by saying, "The
public is so such accustomed to thinking of money as the ulti-te
standard, that, when prices begin to rise, believing that the rise
must be temporary, they tend to hoard their money and to postpone
purchases, with the result that they hold in monetary form a larger
aggregate of real value than before.” J. I. Keynes, A Irgcj; on

W (London: lmcmillan Co., 1923), p.45.

13The writer is greatly indebted to Professor Abba Lerner
for this point.

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124

Case D
100 Rm (Value of individual notes) X 2 (No. of notes) 3 200 Rm
50 Rm (Value of individual notes) X 2 (No. of notes) = 100 Rm
10 Rm (Value of individual notes) XLQ (No. of notes) 3 m Rm

Total 14 400 Rm
D t o f Cu - 2 .6

Na! the average denomination shows a 78 per cent increase,
while the actual prices increase 100 per cent. In this case, the
public behavior in adjusting its note-holdings among the existing
denominations is neglected. If we adjust for this behavior, the
average denomination will be imroved further as a measurement of
price changes.

Because of this action of the Bank, the average denomination
becomes more sensitive to the upward changes in prices than Klein
conceives. In this situation, the problem of lag is somewhat
reduced.

It may be noted that the action of the Bank alone cannot
cause the average denomination to overstate the actual changes in
prices. In case D, the Bank issues 200 Rm notes at best. Some may
think that this action, coupled with the public behavior of
adjusting note-holding among the existing denominations, makes
the average denomination overstate the actual changes in prices.
This seems unlikely. mppose the Bank issues 200 Rm notes. Since

the notes are discrete relative to the existing denominations, the

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125
public any refuse to hold 200 Rm notes. In this situation, there
is no chance of over-statement. Alternatively, the public may
accept the notes willingly. In this case, the‘willingness of the
public to hold 200 Rm notes necessitates little need for adjusting

the previously held note-composition, as may be seen in Case E.

Case E

200 Rm (Values of individual notes) X 1 (No. of notes) I 200 Rm
50 Rm (Values of individual notes) X 2.2 (no. of notes) 3 110 Rm

lO Rm (Values of individual notes) X 2 (No. of notes) ' _gg Rm
Total 12.2 ' 400 R-

e a e D i of Cu e - 32

There seems to be, therefore, little chance of overstating
the actual changes in prices.

The indeterminable contention of Klein now stands on a much
stronger ground than he implies. Discontinuity of denominations is
not really a serious matter when it is viewed with the actions of the
central bank. His second situation, namely, whether or not an
individual wants a given division of the value of total notes, is
not realistic. The essential situation is his first case that an
individual desires no more than the same number of bills with a
rise in prices.

The argument above can be summarized in equations. Since
demand deposits do not exist, according to our assumption, the

total money supply is equal to the total value of notes outstanding.

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126
The total value of notes can be expressed as the average denomdnation
multiplied by the number of notes. Thus, the Fisherian equation can

be expressed as:

(AD.n)v:pT co. (1)
AD ... Average Denomination
N ... "Umber of Notes
I ... Real Income ,
V ... Income Velocity

AD 8 _1_(_1'_) p (2)
V N

It should be remastered that velocity and real income are
assumed to be constant and that changes in other factors attendant
to the changes in the general prices are also assumed to be insig-
nificant in our exposition. ‘lhen the number of notes is the same
before and after price changes so that the ratio of real income
over the number of notes (the N ratio) is the same as in the initial
period, the average denomination and the price level'will be in a
proportional relationship according to equation ( 2 ). In this
situation, the average denomination is a perfect index of price
changes.

‘lhen prices rise, it has been argued above that the average
denomination understates the actual movement of the price level
because of the delay of the public in adjusting its note-holding.
In other words, the I ratio declines because the public holds a
greater number of notes. It has also been argued that the actions

of the central bank tend to compensate that of the public to some

hr- 3-

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94.

m

 

127
extent.
In pursuing our argument, the N ratio has an important
bearing.l4 The relationship between price changes, the average

denomination and the N ratio can be summarized in the following

 

 

 

matrix:

iris; MWit J Rm
goes up understates the actual price changes decreases
goes down overstates the actual price changes increases
WW- Since the accuracy of the

average denomination as a price index depends upon the behavior of
the N ratio, we mast study the imact of changes in income upon
the N ratio. Suppose income changes. How will the N ratio be
affected, assumdng other things remain constant?

lhen income increases and other things remain constant,
obviously the stock of money increases. This can be expressed in

the following three ways:

...Jfll... ...Jl._.. ...JL_._. ...1L__.. ...JL___.

$2 50 1 $1 100
(a) 0 {5
(b) /$.2 o {10
(c) {3.098 {2.5

‘ _ !__ A— _ ._ __ _

14The behavior of the average denomination can be studied by
studying the number of notes, just as we can study consumption spend-
ing by studying the behavior of saving and vice versa.

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128

(a) A 10 per cent increase in T is met by a 10 per cent increase in
I. “That is, the additional requirement for the monetary stock
is met solely by printing additional money of the same’denomin-
ation;

(b) A 10 per cent increase in T is met by a 10 per cent increase in
AD. That is, the additional requirement is met by exchanging
the existing notes with higher values of notes without affecting
the number of notes outstanding;

(c) A 10 per cent increase in income can be met by combining the
above two possibilities. For example, a 5 per cent increase in
N and roughly a 5 per cent increase in AD.15 This means that
the public holds more money in both forms: both more notes and
notes of higher value.

Of all these possibilities, the most probable is the third
case. The first case is not realistic because it precludes the
possibility that an individual may hold higher values of notes as

he becomes richer. In addition, it is not convenient to hold

——‘ —‘ A.— —.—_ __; ____ — *‘A—

f ‘1

15Since V and P are constant in this example, the following
expression is true:

(AD/Mn) (ll/AN) - T {M

AD(1/.A.AP_)N(1/AJL)= HHAL)
AD I T
Since(AD-N) 8?.
(l/AAL)(1/A2L) = I/AI.
AD N T
: .05

LetAJ. : .10, and A!
T N

Then, A“; . 441-1 = .0476 (4.76%)
AD 1.05

I.

.. .-.

 

129

greater numbers of notes. In the second case, it is simply imp
possible to exchange all existing notes into notes of higher values.

when a 10 per cent increase in real income is met by an
increase in N of less than 10 per cent as in the third case, the
N ratio tends to increase. In all probability then, the changes
in real income tend to raise the N ratio. E‘This means that the
average denomination is likely to overstate the actual movement of
the price level.

The relationship between the average denomination and
changes in real income can be explained in another way. when income
goes up, the public, on the average, purchases more of the high-
priced goods. ’For this reason, the public is more likely to hold
higher values of notes even if there is no change in prices. This
tends to raise the average denomination.

Other things being constant, the relationship between changes
in income and the N ratio or the average denomination can be

summarized in the following matrix:

 

Real income Average denomination N ratio
increases overstates the actual price changes increases
decreases understates the actual price changes decreases

__ ——V— —'———— i w—

It is important to recognize that the N ratio or the average
denomination is affected by a factor other than price changes.‘ Thus,
Professor Lerner comments that as real income goes up, monewaill be

held in notes of higher values even if the individual goods bought are

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130
not changed in prices.

lhen prices increase, the price effect alone makes the
average denomination understate the actual price changes, while
the average denomination overstates the price changes when real
income alone increases. In economic phenomena, changes in prices
and real income are comounded. In the matter of the average
denomination, it is important to realize each element of the
compound and the direction of its effect on the average'denomin-
ation.

During the period of this study, prices increased more than
one thousand times while real income increased about two times in
Korea. Thus, price effect is predominant in affecting the average
denomination,:though the increase in real income offsets some of the
tendency of the average denomination to understate the actual price
changes.

W- In previous
discussions, changes in the variables attendent to the changes in
prices! real income, real value of cash balance, relative prices

and the changes attendant to the changes in real income, are

assumed to be constant or insignificant. Let us remove these
assumptions.

Real income and the real value of the cash balance can be
treated as the same thing for our discussion. 'lhen real income fails
as prices ihorease, it tends to reduce the N ratio more than when

the price changes alone. Therefore, the average denomination

 

I.

131

understates the actual prices further.

Price changes, however, bring about a sectorial impact
on real income. For example, as an economy develops industrially
the terms of trade may fall in the agricultural sector, thus
enriching the industrial class of the population. This effect of
the income redistribution will affedt public note-holding in such a
way that higher denominations of currency will be held among the
industrial class. This means that the N ratio and the average
denomination tends to increase.

Price changes also bring about changes in relative prices.
The average denomination of currency either goes up or down, depend-
ing opon‘whether price changes occur in relatively high-priced goods
or in low-priced goods.

lhen income increases, general prices are subsequently
affected. The subsequent increase in prices tends to reduce the
N ratio.

when we remove the assumtions concerning the subsequent
changes in other variables, the analysis becomes confusing. The
attendent changes in other variables caused by the primary changes
in income and prices can be roughly classified into two categories:
income effects and price effects. These two effects are secondary
in force and move in opposing directions. The extent that the N
ratio is affected by these opposing tendencies depends upon the
balance of these effects.

This brief discussion about the theoretical ground for the

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132
use of the average denomination needs some modification. It was
assumed that velocity is constant and the total money supply is com-
posed solely of notes. Although velocity was argued to be relatively
constant over the period of this study, velocity has been changed in
particular years, for exaaple, in years of war, truce and political
instabilities.

lhen checks are introduced in our exposition, the analysis
is not as simle as previously described. Both velocity and the
use of checks are the very factors that affect the number of notes
and the average denomination. These factors should be incorporated
in the analysis. This study, therefore, needs further refinement
and extension.

The argument presented above, however, does not lose the
main idea of the average denomination. The argument seems to lead
to the conclusion that we can attach some iaportance to the use of
the average denomination as a price index, especially when reliable
data are not available. The method and data used in comuting the
index of average denomination are presented in Chapter A, Appendix.
A comarison of the index of average denomination and the Seoul

lholesale Price Index is made in Chapter 8, Appendix.

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133

3. The Nbvement of Pricefiégvel

The annualaverage of the index of the money supply rose 1,136
times from 1946 to 1960, while the index of the average dennmination
and the index of Seoul Wholesale Prices rose 878 and 392 times
respectively. In this section interpretations of price indices for
several periods will be made in relation to prevailing economics
conditions. The interpretations, however, are very tentative. For
an intelligible interpretation, much more detailed study of the price
level and the money supply is required. An attempt in this section
is made only to indicate some contrasting behavior of the two indices
by a very crude method.

Quarterly data and a graph of the index of the money supply,
the average denomination, and Seoul wholesale prices are presented

in Table 13 and Chart 1 reapectively.

A. The Period of Currency Reform

The index of the average denomination shows a 499 per cent
increase from January to February, 1953. Before we go into the
analysis of separate periods, the method of Splicing the average
denominations and a tentative explanation of the sharp increase of
the average denomination should be made.

Since computation d? the average denomination is based on
the denominational distribution, two average denominations, one in
terms of the old currency and the other in terms of new currency, are
connected as one index. The currency reform made 100 won of the old

currency equal to l hwan of the new currency. The new average

:ul

 

134
denomination can be multiplied by 100 in order to convert the new
average denomination into the old denomination. The starred figures
under the column of the old average denomination in Table 11 are the

converted figures based on the reasoning above.16

TABLE 11

CONNECTING THE NEW AVERAGE DENOMINATION TO THE OLD AVERAGE DENOMINATION

 

 

 

New Average ‘ Index

 

Old Average Percentage
Denomination Denomination '47-100 Change
1953, 1 757.953; 1,805 8.7
2 4,540.757* 45.395 10,811 499.0
3 4,859.012 48.577 11,566 7.0
6 mus/.049: 31.462 7,491 -35.0
9 2,621.408* 26.207 6,240 16.7
12 2,911.486 29.107 6,930 11.1

 

Does a 499 per cent increase in the index of the average denom-
ination from January to February reflect the true movement of prices?
The index of the average denomination seems a fictitious index. The
percentage distribution of denominations before and after the currency
reform is presented in Table 12. This table indicates that higher
value notes were held by the public after the reform presumably because
the government fed the higher value notes to the publiccn the occasion
of the reform. This means that the average denomination after the
reform was greater than before. Therefore, changesin the denominational
structure largely explain the sharp increase in the index of the

average denomination independent of actual changes in prices.

 

16In my computation I inadvertently used the factor 100.027
instead of 100. The effect of this error, of course, is negligible.

135
TABLE 12

PERCENTAGE DISTRIBUTION OF DENOMINATION*
BEFORE AND AFTER CURRENCY REFORM

 

 

 

(In Hon)
Denominations
Date in won 100,000 50,000 10,000 1,000 500 100 10 5 1
1952 12 98.8 .1 .8 .l .01 .01
1953 1 98.8 .18.84 .12 .01 .01
Currency Reform

1953 2 14 - 76.5 8.3 1.2 .2

1953 3 Meg " 75e5 8e1+ e99 e2

1953 4 J-A-el "' 74a? 1094 e63 e2

1953 5 no? - 71.0 l5e6 e48 e17

 

*New denomination is converted into old denomination: 1 hwan
is equal to 100 won.

Source: The Bank of Korea, The Economic Annual, 1955 (Seoul:
Bank of Korea, 1955), pp. s-21.

Alternatively, the argument that the 499 per cent increase in
the index of the average denomination is fictitious can be shown by
guaging the effect of denominational change upon the changes in the
average denomination. The average denomination before the reform was

as follows:

Prior to the Currency Reform: (January 31, 1953)
Notes held by public 1,002,400.000 Won
Average denomination 757.953 Mon
Suppose that the structure of denomination of currency remains
the same before and after the currency reform. The reform made 100 won
of old currency equal to 1 hwan of new currency. The average denomin-
ation of new currency, therefore, should have been 7.57953 hwan if

the money supply were the same after the reform. That is, if a pair

136

of shoes was bought with 757.953 won of old currency before the reform,
the same pair of shoes could have been bought with 7.57953 hwan of new
currency after the reform.

At the end of February the total money supply available to
the private sector, notes in circulation and private demand deposits,
was reduced by approximately 36 per cent, 4.4080 billion hwan. Notes
in circulation were reduced by roughly 31.3 per cent, 3.134 billion
hwan. According to the rigid version of the quantity theory of money,
a preportional decline in prices should have accompanied the reform.
Since the amount of notes in circulation has a higher correlation than
deposits with the wholesale price level,17 it is assumed that the price
level will decline in prOportion to the decline of the notes in circu-
lation, 31.3 per cent. Therefore, the same pair of shoes would have
been bought with 5.20729 hwan after the reform.

Therefore, the index of the average denomination of currency
after the currency reform should have been 5.20729 hwan. Actually,

the average denomination of notes after the reform was 45.395 hwan.

After the Currency Reform: (February 31, 1953)
Notes held by public 6,890.000 hwan
Average denomination 45.395 hwan
This means that the price level was about 8.72 times higher than it
should have been if the nominal prices were to decline from 100 won to
l hwan. The factor of 8.72 is the highest effect of the denominational

changes Upon the average denomination under the assumption that the

 

l7James LL Angell, The Behavior of Meney (New York: McGraw—
Hill Co., 1936), pp. 12—61.

 

137
strict quantity theory of money is applicable to the process of
currency reform. Nhen the quantity theory does not apply, e.g.,
velocity increases as the money supply decreases, the size of the
impact of the denomination change will be reduced.

It was noticed that the index of the average denomination,
or the index of price level, rose by a factor of about 5 before and
after the currency reform. The factor of 5 is combined effects upon
the changes in the index of average denomination, and the factor of
8.72 is the effect of the structural change of the denomination
caused by currency reform. In view of the fact that the size of
impact of the denominational change upon the average denomination is
greater than changes in the price level, it is safe to say that
changes in the index caused by the currency reform are mainly due
to the change in denominational structure.

As shown in Chart 1, the index of average denomination declined
from March until September. This may imply that the public was adjust-
ing its note-holdings during this period. That is, during the currency
reform the public held higher value notes than what it desired to hold.
As time passed, the public gradually switched from the higher to the
lower value notes in order to obtain its Optimum situation of note-
holdings.

During the period of adjustment, the index of the average
denomination did not reflect the actual changes in price level. During
this period, therefore, an intelligible comparison between the index
of the average denomination and Seoul whiesale prices cannot be made.

For this reason, in the following discussion 1953 is excluded.

138
Once the process of adjustment was completed, the index of
the average denomination reflected changes in prices as the theory

developed in the previous section indicates.

B. The Over-All Period

The quarterly average of 1947 is the base for the index of
average denomination of currency, money supply and the Seoul kholesale
Price Index. It should be mentioned that there was no single year of
stability in Korea between 1945 and 1960. Therefore, it is necessary
to select a rglgtiyely stable year as the base. The year 1947 seems
to meet this requirement, although there was a substantial increase
in prices during this year. Also the Seoul Wholesale Price Index
uses 1947 as the base year.

According to Chart 1, the over-all picture of the index of
average denomination shows, with the exception of 1953, a relatively
more stable movement of price changes than the Seoul Wholesale Price
Index. This is due to the difference in nature of the reSpective
indices as is described in Chapter B. Appendix. The Seoul Wholesale
Price Index reflects changes in wholesale prices in Seoul, while the
index of average denomination reflects price changes of the total money
sector of the economy.

The index of average denomination rose faster than the whole-
sale prices in 1945 and from 1955 on continuously, while it rose more
slowly than the wholesale price index from 1946 until 1952. This
indicates that the rate of price changes shown by the index of average
denomination is less than that of the wholesale price index at an

earlier period, while it is greater in the later period. If we assume

139
TABLE 13
INDEX OF AVERAGE DENOMINATION, SEOUL WHOLESALE PRICES,

mm MONEY SUPPLY, 1945 - 1960

 

Index of
Index of Wholesale %Change Average
a 5 Money 96 Change Price Wholesale Denomination %Change
g g 1947-100 in Money 1947-100 Price 1947-100 161:. 1.11.

1945, 9 28.0 11.2 45.0
12 31.6 12.9 11.8 5.4 49.0 8.9
1946, 3 36.1 7.9 48.8 313.6 51.6 5.2
6 39.2 15.0 51.6 5.7 50.6 ~2.0
9 50.2 2.0 96.4 75.2 59.6 17.0
12 7205 4500 74.4 -1707 77.3 2909
1945746 129.4 530.5 57.7
1947, 33 76.7 5.8 89.6 20.4 83.7 8.3
6 84.5 10.2 89.8 .2 91.0 8.7
9 96.7 14.4 102.3 13.9 100.5 10.4
12 114301 4800 1112.4 3902 12408 240']-
1946-47 97.4 91.4 61.3
1948, 3 144.6 .63 149.2 4.8 126.6 1.4
6 152. 6.1 162,7 9.1 133.2 5.3
9 168.7 10.4 180.1 10.7 146.2 5.3
12 196.5 16.5 185.0 2.7 159.3 13.6
1947948 37.3 29.9 27.7
1949, 3 207.3 5.5 177.7 ~4.0 153.5 -3.7
6 218.3 5.3 201.6 13.5 156.6 2.0
9 290.1 32.9 254.7 26.3 163.3 4.3
12 340.4 17.3 288.9 13.4 182.5 11.7
1950, 3 317.4 —6.8 332.3 15.0 174.2 «4.5
6 332.9 4.9 348,0 .7 176.4 1.2
9 406.5 22.1 __ - 260.4 47.7
12 77409 90.6 831.1.“ "" 627.4 14009
1949-50 127.6 187.7 243.8

 

Seoul Wholesale Price Index is connected to Pusan Wholesale
Price Index from December, 1950, to the end of 1952. Seoul
index was not possible to publish during this period due to
war conditionsq

1.).“

140
TABLE 13 Continued

 

Index of Wholesale % Change Index
Money % Change Price Wholesale of A.D. % Change
1947-100 in Money 1947—100 Price 1947—100 in I.A.D.
1951, 3 1,1320 4601 "‘ " " " 84003 3309
6 1,421. 25.6 1,670.8 - - 1 061.3 26.3
9 1,700. 19.6 2,550.0 52.6 1 251.2 17.9
12 2 093. 23.1 2,599.2 1.9 1 413.1 13.0
1950-51 170.2 212.7 125.2
1952, 3 2,412.4 15.2 3,676.5 41.5 1,539.9 9.0
6 2,787.1 15.5 5,136.6 37.7 1,591.2 3.3
9 3,234.2 16.0 6,197.7 20.7 1,660.7 4.4
12 4,172.0 29.6 5,256.8 —15.2 1,791.8 8.0
1951-52 559.3 102.3 26.7
1953, 3 3,673 —12.0 5,974 13.6 11,566 545.4
6 4,861 32.3 6,147 2.9 7,491 -35.2
9 6,778 39.4 5,870 -.5 6,240 —16.7
12 8,086 19.4 6,635 8.6 6,930 11.1
1953-53 93.8 26.2 286.8
1954, 3 9,682 1907 6,135 '705 8,137 1704
6 12,212 26.2 6,730 9.6 7,764 ~4.6
9 13,400 9.7 9,108 35.3 8.340 8.2
12 15,492 15.6 16,037 16.2 9,644 14.8
1953-54 91.6 51.2 39.2
1955, 3 15,509 .1 11,508 14.7 13,554 40.5
6 17,355 11.9 14,012 21.8 17,081 26.0
9 20,162 16.2 14.729 26.5 21,044 23.2
12 24,946 23.7 14,330 -18.2 21,256 1.0
1954-55 61.0 42.8 120.4
1956, 3 24,045 -3.6 15,471 8.0 21,050 -1.0
6 26,410 9.8 20,013 29.4 21,493 2.1
9 27,733 5.0 21,524 7.5 21,044 1.9
12 32,255 16.1 26,950 -2.7 23,256 8.3
1955-56 29.3 46.2 11.6
1957, 3 30,072 —.6 22,499 7.4 26,771 12.9
6 31,819 -.8 23,499 4.1 29,147 8.9
9 33,355 4.8 22,554 “3.7 28,517 -2.2
12 38,726 16.1 19,503 -1305 27,442 -308

141
TABLE 13 Continued

 

Indexof
5 Index of C lholeaale X Change Average
8 a Money % hange Price lholeaale Denouin. X C:hange
,0. :9 1947-100 10 Money 1947-100 9:16. 1947-100 1:: 1.1.0.
1956-57 me 1 -7.0 15o 7
1958, 3 39,225 1.3 19,873 1.9 27,976 2.0
6 39,782 1.4 20,707 4.2 28,186 .8
9 44,220 11.2 22,297 2.7 28,880 2.5
12 51,361 16.2 21,142 .6 31,473 8.7
1957-58 32o 6 8e 4 14o 7
1959
1959, a 56,204 9.4 20,423 -3.4 34,370 9.2
6 55,136 - 2.0 21,950 7e5 36,078 500
9 54,338 - 1e4 ”,617 7e6 36,679 1e?
12 55,988 300 23,605 -01 38,539 501
1958-59 9.0 11.7 22.4
1960, 3 56,301 .6 24,727 4.8 44,564 15.6
6 55,188 -2.0 3,804 4e6 50,892 14.2
9 53,155 ‘3e7 %,941 4e4 55,035 8e].
12 58,436 10.0 5,689 ’4e6 59,5“ 8.2
1959-60 4.3 8.8 54.5

Source: Index of the Money Supply free Table 8, Chapter V,
Index of Seoul wholesale Prices from Outline of Pricee ( Seoul:

Bank of Korea, 1961), pp. 178-5. Index of the Average Denomination
from Table A. Appendix.

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143

that the wholesale price index is an accurate measure of price changes,
the above fact may indicate that the index of average denomination
understates or lags behind the actual movement of price changes in the
earlier period, while it overstates the actual movement of price
changes in the later period.

Perhaps a better explanation may be found in the relationship
between the index of money SUpply and the respective price indices.
In general, velocity declines during the early period of the inflation-
ary process, while it increases in the later period. For example,
Keynes states:

The public is so much accustomed to thinking of money as

the ultimate standard, that, when prices begin to rise

believing that the rise must be temporary, they tend to

hoard their money and postpone purchases, with the result

that they hold in monetary form a larger aggregate of real

value than before. . .But sooner or later the second phase

sets in. The public discovers that it is the holders of

notes who suffer taxation and defray the expenses of

government, and they begin to change their habits and to

economize in their holding of notes.

Throughout this period of study, inflationary forces existed in
Korea. Let us confine ourselves to two periods, one from September,
1945, to June, 1950, and the other from March, 1954, to the end of
1960. The period of war and currency reform are excluded in this
exposition.

In the earlier period, the wholesale prices rose 31 times and

the money supply increased 11.9 times, while the wholesale prices rose

only 4.2 times and the money supply 6 times in the later period. The

 

18J. M. Keynes, A Tract on Mbnetarngeform (London: Macmillan
00., 1923), p. 45.

144
fact that the index of Seoul Wholesale Prices rose faster than the
index of the money supply has been interpreted as an indication of
violent inflation and an increase in velocity. A very good example
of this is illustrated in the next section.

Closer study of the data indicates that most of the rise in
prices is concentrated in 1945. As will be detailed in the next
section, this huge rise in prices in 1945 is fictitious. From.March,
1946, to June, 1960, the money supply increased 9.25 times and Seoul
index 7.1 times. Seoul hholesale Price Index implies 30~LO per cent
increase in velocity allowing 60—70 per cent increaSe in real output.
when we exclude 1945 and 1946, it appears that the behavior velocity
implied by the Seoul hholesale Price Index is nearly constant.

In the earlier period as a whole, as is often interpreted in
Korea, prices rose faster than the money supply, and vice versa in
the later period.

This interpretation, if true, indicates a very peculiar
economic behavior. Namely, velocity declined in the period following
Iwar, prolonged inflation and currency reform. In this period
political instability was also observed. On the other hand, velocity
increased during the period when expectation for a brighter future,
in general, was held among the public. This behavior seems to be quite
contrary to what would normally take place.

In the earlier period, the index of average denomination
increased 3.9 times and the index of money supply 11.9 times, while
the index increased 6.2 times in the later period and the money supply
6 times.19 Although the decline in velocity is rather great in the

earlier period,cthe'indéx of average denomination seems to prOVide

 

191m Chart 1 the index of average denomination lies below the
index of money supply due to the difference in the base year.

145
aimore‘sensible interpretations offthe‘directiOn"of7velocity than the
wholesale price indexifor both periodsgo37 - ""TJ.LV

One may question the rather long period of declining velocity
in the midst of constant inflationary forces. This means that the
public did not revise its expectations during the earlier period,
roughly five years. This is entirely possible. One reason for this
is the fact that the agricultural sector occupies a great portion
of the total economy. Also there occurred a rapid expansion of the
money sector of economy due to the land reform and the extensive
government programs of farm product purchases. Perhaps the most
important explanation for the period of declining velocity is the
fact that the expectation for a bright future was not fulfilled in a
once-and-for-all fashion. Bright eXpectations materialized contin-
uously as seen by the liberation of August, 1945, the occupation by
the Military Government and the land reform of 1947 and the estab-
lishment of the Republic of Korea in 1948. There hardly seems to be
any discontinuity of bright expectations over the whole period.

An increase in velocity in the later period, which seems to
be more reasonable, implies that the Seoul Wholesale Price Index is
understated. The main reason that the Bank of Korea continued to
publish the Seoul kholesale Price Index, despite its admission of the
defects of the index, is because of the agreement between the United

States and Korea to revise exchange rates when the wholesale price index

increases 25 per cent above the level of the preceding period. The

 

20This argument cannot hold strongly against the Seoul Whole-
sale Price Index for 1947-1950 because of the relatively constant
behavior of velocity implied by the index during this period.

146
agreement was to raise the rate of foreign exchange as the index of
Seoul wholesale prices increases. The increasing exchange rate has
been a very keen issue in Korea. In particular, the rise in exchange
rate was calsidered to cause further inflationary spiraling. There-
fore, it is feasible that the government may have manipulated the
wholesale price index from 1954 on in order to show its success in
controlling inflation in an attempt to prevent the possible rise of
the foreign exchange rate.

In this connection, an example may be quoted from the Economic
Survey of 1959, published by the Ministry of Reconstruction.

Until 1957 there had been a preportional relationship

between the money supply and the price level so that

a change in money supply caused a pr0portional change

in the price level. . . .In 1958 several factors

[ihich caused velocity to declingi caused a diver-

gence between price movements and money supply which

the Korean economy had never before experienced.

This statement indicates that there were divergent movements
between the price level and the money supply, which the government
claims occurred after 1958.22 During 1958 the money supply increased
32.6 per cent, while the Seoul Wholesale Price Index indicates an
increase of 8.4 per cent. The difference is explained by the decline

of velocity, which was roughly 20 per cent, taking into account the

6 or 7 per cent increase in real output in 1958.

 

21Ministry of Finance, R.O.K. Economic Survey, 1959 (Seoul:
Ministry of Reconstruction, 1959), pp. 18-20.

 

 

22The divergent movement that the government claims to have
appeared after 1958 seems to have taken place after 1954, according
to the index of the average denomination.

t ...r. I}
a:

147

The quarterly average of demand deposit velocity during 1958,
however, shows a 0.1 per cent decline in 1958, which is negligible.
Since the government and the Korean Agricultural Bank used about
65 billion hwans for the purchase of rice and for loans, a high amount
compared with the previous year, the diSpersed money in the agricul-
tural sector may have caused some decline in the velocity of the total
money supply in 1958, but not to the extent of 20 per cent.

The index of the average denomination indicates a 15 per cent
increase in prices and less than a 10 per cent decline in velocity.-
In view of the behavior of demand deposit velocity and economic con-
ditions prevailing in 1958, the decline in velocity implied by the
Seoul Wholesale Price Index seems to be too far removed from what
could actually happen. If this is the case, the index of wholesale
prices understates the actual movement of price level to the extent

of excessive decline implied by the wholesale price index.

C. The Post-Liberation Period

During the Second'hbrld War there existed strong inflationary
pressures within Korea. This was eSpecially true toward the end of
the war. The Japanese policies, however, had managed to control the
rise of prices with wide-scale price control, collection of staple
foodstuffs and well-organized rationing schemes. The index of whole-
sale prices thus rose by 176 per cent, although the note issue of the
Bank of Chosen rose about 1900 per cent from the end of 1936 to June,
1945.23 Regarding the movement of price changes for the period after

the liberation, all Korean economists and some distinguished American

 

23The Bank of Korea, The Outline of Priceg, p. 8.

148
economists interpret the economic phenomena as characterized by
pronounced inflation and the rapid increase of velocity. Professor

Bloomfield, for example, states in his Banking Reform in South Korea:

 

From September 30, 1945, to March 31, 1950, the money

supply rose to 1033 per cent, whereas wholesale prices

rose 2867 per cent. This points to an increase in the

velocity of circulation of money over the period as a

whole, such as would be expected at a time of pronounced

and prolonged price increases.

He indicates that prices and velocity rose at a much faster
rate during 1945 and 1946. This is clear in another statement made by
him that prices rose about 20 or 25 times in the two months preceding
the arrival of the American forces and that there was a "mad rush" to
buy up all goods available.25

This interpretation, in my Opinion, misrepresents the movements
of prices, velocity and other economic variables in this period, but it
was accepted by policymakers in Washington and Seoul.

Assuming that the real output remains the same (decline of
real output was inferred by Bloomfield, Lewis, and many others),
three times increase of velocity is implicit in Bloomfield's statistics.
He states later that "the only surprising thing is that the inflation

did not develOp into a runaway inflation."26

 

 

24A. I. Bloomfield and John P. Jensen, Banking_Reform in Sggth
K9323 (New York: Federal Reserve Bank of New York, 1951;, p. 32.

ZSBloomfield and Jensen, Ibid., p. 27. See also Jehn P. Iewis,
Reconstruction and Development in South Korea, p. 10. He states: "The
financial upheavals and slump in production associated with the Japanese
exodus immediately swept the economy into its first wave of violent,
runaway inflation."

26Bloomfield and Jensen, pp. git., p. 33.

.0... ..gdl -...1.1.. ..1 ._ 1.”

r

149

This interpretation seems to have resulted from treating the
elimination of discrepancy between the controlled and uncontrolled
prices as an inflationary process.

In evaluating the movements of price changes, it should be
noted that we refer to uncontrolled prices in the free market. In the
chaotic situation resulting from the liberation August, 1945, of Korea,
the elaborate system of controls broke down completely. In October,
1945, the Military Government had formally decontrolled all commodities
and established free markets. The break-down of price control eliminated
the discrepancy between the Open market price and the controlled prices.
The 530.57 per cent increase of prices shown by the Seoul Kholesale
Price Index in Table 13, therefore, seems to reflect a good portion of
the discrepancy. Table 14 is helpful in substantiating this point.
According to the Seoul Wholesale Price Index, prices rose to 11.2 in
September from 0.687 in June, 1945. Prices rose about 1500 per cent
during this period. Therefore, the major portion of this 1500 per
cent seems to be the discrepancy which was eliminated right after the
break-down of price control. (The difference in prices from Ju1y to
September will give a better approximation of the discrepancy. However
the price index of July and August is not available.)

The wholesale price index shows about a 314 per cent increase
between December, 1945, and march, 1946, as seen in Table 14. On
the other hand, the index of average denomination rose only 5.2 per
cent during the same period. The difference between these two indices
may be explained by the decontrolling policy of the government. The
United States military government officially decontrolled the prices

in October, 1945. Thus, the remaining discrepancy of the Index of

150
Seoul Wholesale Prices should have been gradually eliminated from then
on. By March, 1946, it seems that the discrepancy between the two

price levels was eliminated completely. They advanced together after

 

 

that date.
TABLS 14
BREMiDOhI‘J OF PRICE, 1945 - 1946
Seoul Wholesale Index of Average
Price Index Denomination
1947-100 % Change 1947:100 % Change
1W5,6 .&W
9 11.2 1500 45.02
10 9.3
11 9.4
12 11.8 49.04 8.93
1946, 3 48.8 313.6 51.59 5.20
6 51.6 5.74 50.58 -l.96
9 90.4 75.2 59.55 17.73
12 74.4 17.7 72.33 29.86

 

Source: Seoul Wholesale Price Index from Outline of Prices
(Seoul: The Bank of Korea, 1961), p. 174.

 

that was the behavior of velocity immediately after the liber-
ation? The money supply increased about 130 per cent during the period
from 1945 to 1946. This is much less than the change in the index of
wholesale price and higher than the index of the average denomination
of currency. Two different explanations of economic activities,
eSpecially the behavior of velocity, can be made.

Let us first confine analysis to the period of 1946. Accord-
ing to the Seoul hholesale Price Index, velocity increased roughly 290
per cent during 1946, while it declined by 70 per cent according to
the index of the average denomination, if we assume real output remained

the same. When velocity is assumed to remain the same, real output

151
declined 290 per cent according to the Wholesale Price Index, while
it increased 70 per cent according to the index of the average
denomination. In fact, both velocity and real output must have
changed during this period. In this case, the magnitude of changes
would be less than as indicated above.

From August, 1945, to 1946, it was observed that no prOper-
ties and goods connected with the Japanese in any way had market
value because almost all Koreans refused to purchase anything from
the Japanese. Optimism caused by the liberation and various decontrol
measures must have eliminated the behavior of hoarding goods which
was very pepular during the tight control schemes. Therefore, this
dis-hoarding behavior and the abandonment of goods and prOperties
must have increased the real goods available. In this condition, it
is more likely that velocity would have declined rather than increased.
At least until the middle of 1946, the post-liberation period was one

period
of the most Optimistic/in Kerean history. Evidences indicate that
interpretation of economic activities based on the whiesale price
index is not a sensible one.

The average denomination, therefore, appears to be a more
sensible index. During 1946 prices had risen 58 per cent. The increase
in real output and the decline of velocity had offset the effect of an
increase in money supply.

During the period of post-liberation, prices rose at a rather
high rate. There appeared, however, a relatively stable tendency
after the establishment of the Korean government. It was relatively
stable in the sense that there was no tendency for the rate of price

increases to accelerate.

 

152
D. The Korean War Period

The causes of inflation following the invasion of June,

1950, are easily eXplained. On the supply side there were increasirgly
severe shortages of all kinds of goods and services. A description

of the South Korean economic situation during this period emphasizes
the word "shortage" repeatedly. The rapid increase of money supply,
127 per cent in 1950, was accompanied by a reduction of the supply of
goods due to the thorough disorganization of trade and the decline of
production. Money was concentrated in a small Pusan area and velocity
increased during this period.

Thus, prices rose 244 per cent in 1950 according to the index
of average denomination, while Seoul hholesale Price Index shows a
188 per cent increase in prices.

In 1951 prices rose 125 per cent, according to the index of
average denomination, a very high rate, yet a much lower rate than
that of the previous year. By 1951, especially after the participa-
tion of the Chinese Communists, there was a tendency to settle in
Pusan temporarily. In a different environment, somehow the reorgan-
ization of economic institutions and organizations was undertaken.

At the same time the government enforced a tight money policy.

In 1952 trade and transportation improved significantly after
two years of confusion. The banking system also stOpped the mad
expansion of credits. Prices rose about 27 per cent during this
period according to the index of average denomination, while the
tholesale Price Index showed a 102 per cent price increase.

The rumor of a truce at Panmunjum seems to be important in

explaining the above contradiction. After a series of conflicts about

153
the truce agreement between the United States government and President
Rhee, the negotiation of a truce was considered inevitable. This
feeling spread among the public and the rumor began to make more
sense with the arrival of UNKRA in Korea toward the end of 1951.
The public and the Korean government anticipated the return of the
government and the public to Seoul from.Pusan. As a result of the
expected return the peOple anticipated expenditures in Seoul. Thus,
velocity must have declined in 1952. This decline in velocity offset
the effect of money supply, which resulted in a relatively low rate
of price increase. Real output increased during this period. For
example, the arrival of foreign aid increased sharply during 1951 and

again it increased about 50 per cent in 1952.27

In 1952 imports
also increased about 40 times over 1951.28 Pusan was swamped with
imported flour at one time. In such a situation, it is hardly

possible for prices to increase at a faster rate than money.

E. The Period after Currency Reform

Price increases started to pick up from the fourth quarter
of 1953 and through 1954, except for the second quarter of 1954,
probably because of increased demand for reconstruction after the
government moved back to Seoul. Despite this fact, the price level
in 1954 was relatively stable. 7

An interesting observation is the sharp contrast of price

increases between the average denomination and the wholesale price

27The Bank of Korea, Economic Annual, 1955, p. 161.

 

281bid., p. 173.

”it?“

i'

ll-

154
index during 1955. Prices rose 120 per cent in 1955 according to
the index of average denomination, while only a 43 per cent price
increase is shown by the Wholesale Price Index. This sharp contrast
needs some explanation.

According to the Wholesale Price Index, about a 51 per cent
price increase was observed in 1954, the year after the currency reform.
western economists, especially the United States officials, engaged in
economic reconstruction programs, were sadly disappointed by the
continuous price increase, observed by the Seoul Wholesale Price
Index (prices rose 35 per cent and 16 per cent in the third and
fourth quarters, reSpectively), and rapid monetary expansion since
the currency reform. In order to maintain price stability, the United
States representatives at the C.E.B. once again suggested a deprecia-
tion of exchange rates in the fourth quarter of 1954. This was met by
a sharp reaction from the Korean government. Thus the supplies of aid
goods, especially gasoline, oil and other strategic materials, were
all cut off. Such actions of the United States met with a sharper
reaction on the part of the Korean government, until political uncer-
tainty was created. There was a rumor that the United States might
give up Syngman Rhee¢s government. Thus, the general price level
rose sharply in the first, second and third quarters of 1955. The
stability of the price level in the fourth quarter seemed to be the
result of the good crOp of the year and also the repeal of the increased
charges of government utilities, which were initiated in August by the
government in order to maintain the revised exchange rate after the
depreciation./I£he index of average denomination being correct, the

index of the Seoul wholesale prices is sadly in error.

155

Unlike the wholesale price index, the index of average denomp
ination was relatively stable only up to the third quarter of 1956.
Since then, price increased until the second quarter of 1957. The
Financial Stabilization Policy was implemented in the second quarter of
1957, which made the price level relatively stable until the third
quarter of 1958.

Never before in Korean history has there been a period like
1957-1960 in which emphasis on price stability was made. This, of
course, doesn't mean that the Korean government seriously realized
the importance of price stability.29 For many reasons, somehow the
government had to implement the tight money policy. During 1957
the money supply increased approximately 20 per cent, about 9 per cent
less than the previous year. Yet the price movement shows a divergence
between the index of average denomination and the wholesale price index.
The wholesale price index shows a 7 per cent decline, while the index
of average denomination shows a 16 per cent increase. According to the
wholesale price index, velocity declined about 20 per cent, taking

into account the 7 or 8 per cent increase of real output.30 The index

 

29For example, the Economic Survey of 1959 states, "It allowed
some flexibility to supply apprOpriate funds for productive industries
so that the deveIOpment of industry would first increase production
and then stabilize prices. This plan emphasiggd growth of prgdpgtion
and_price stability rather than the volume of money_supp1y itself.“
(underlined by writer) (Seoul: Ministry of Reconstruction, 1959), p. 16.

 

30The national income at 1955 constant prices, published by
the Bank of Korea shows a 7 per cent increase in 1957. NW'crude index
of real output indicates 18.5 per cent. This higher increase of real
Output seems to be caused by a 4.5 per cent decline of real output in
the previous year. The national income data doesn't Show the decline
in the previous year. See Chapter C, Appendix.

156

of average denomination shows about a 3 to 4 per cent increase in
velocity. The demand deposit velocity indicates relative constancy
over the previous year.

The movement of price level during 1958 is already explained
in Section B of this chapter.

Prices rose steadily in 1959 and rather rapidly in 1960, an
election year. Despite the rather slow rate of the increase in money
supply, both in 1959 and 1960, prices rose at a much faster rate than

the money supply.

E. A Brief Summary

In the regression analysis in Chapter B, Appendix, it was
pointed out that the index of average denomination and Seoul Whole-
sale Price Index are different in nature. Seoul Wholesale Price
Index reflects changes in wholesale prices in Seoul, while the index
of average denomination reflects changes in prices in the total money-
sector of the Korean economy. In the analysis of inflation of the
total economy, the use of the index of average denomination seems
preferable to Seoul Wholesale Price Index.

Although interpretations of price indices are very tentative,
some meaningful insights in understanding the true movement of price
(level was obtained by the index of average denomination. For example,
the index of average denomination seems to support Keynes' hypothesis
as is described in Sub-section B. The behavior of velocity implied by
Seoul kholesale Price Index seems quite opposite to Keynes' hypothesis,

with the exception of 1947-1960.

157

As expressed by Klein, the index of average denomination seems
to provide better insights in studying the true movement of price
level during the period of repressed inflation. The index of average
denomination points out that Seoul Wholesale Price Index understates
the price level after 1954.

The index of average denomination, however tentative the
interpretations made in this section may be, provides challenging
views in understanding price level. It also cautions the uncritical

use of Seoul Wholesale Price Index in economic analysis.

CHAPTER VII

REATIONSHIP BETWEEN “DIETARY POLICY A?!) EOPDIIIC DEVELOP“

11.1mm

In the literature ebout depression, postdwer recovery end the
economicldevelop-ent of underdeveloped countries, the reletionship
between growth end price stebility hes been controversiel. This
hes necessarily been so because the issue involves not only economics,
but elso socio-politicel problees.

‘ Sewn ergue thet price stebility should precede growth, while
others insist upon recovery before price stability. The recent
lilitery revolution of Koree in 1962 see-s to be deter-ined to seek
growth end price stebility et the sens tine. The nilitery revolution,
in wy opinion,‘wes lergely due to the feilure to weintein stability
in the pest.

The study of prices end money in the lest fifteen yeers in
Korea reveels sherp conflicts concerning whether or not reconstruction
should be sought before price stebility. The Fifteen Point Economic
Progrel of 1950 end the Agreeeent ebout Finenciel Stebility end
Reconstruction of 1953, essentielly ewphesized price stability before
economic reconstruction. This emhesis seems to heve been besed upon
the persuesion of the United Stetes representetives et the Office of
the Coebined Boone-1c Board. The retionele seeen to heve been: in-

flation is to be evoided beceuse reconstruction requires invest-ent;

158

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159

investment will not be forthcoming until prices are stabilized and the
balance of payments made ”viable” without United States aid.

However, the basic line of economic policy contenplated by the
Korean government was contrary to that of United States representatives.
The government sought reconstruction before price stability. A high
rate of economic development or speedy recovery became a sine guo no .
Naturally, the emphasis of the reconstruction policy was put on the
increase of real output. However, it was not understood then that an
attempt to increase real output financed by bank funds would directly
lead to the increase in aggregate spending unless a decline in velocity
‘would offset the increase in money supply, It was also not understood
that the increase or changes in the comosition of demand would not
automatically lead to the increase or changes in the composition of
supply. A

In reviewing the literature, it is often found that the
increase in aggregate demand is considered to be good for economic
reconstruction or for a higher level of employment and national
income.1 By and large, no monetary expansion'was seriously con-
sidered inflationary so long as production would increae sooner or

1Practically no economist in the field of public finance in
Korea agrees‘with the balanced budget theorem. The theorem is treated
as a historical relic. It is natural to emphasize the importance of
fiscal policy in economic growth, but some hold fiscal policy respons-
ible for increasing the level of incoaa by increasing the aggregate
demand. See: Lee Hae Dong, "Distress of Public Finance“ Mug
(Seoul: Jae Jeung Sa, June 1956), p. 48.

C

hr:

---¢-- Q

..

e.

160

later.
The view observed above may be due to the habit of reasoning

by analogy. as. if .E The experience of the role of government in

Japanese development, the American experience and the misunderstand-

3

ing of Keynesian economics might lead to the conclusion that govern-

Ament deficit spending is essential in capital formation and that
lower interest rates shouldbe the focus of monetary policy. The
Five-Year Economic Plan of 1951 and the establishment of the Korean
Reconstruction Bank in 1954 can be presented as evidence for this
line of policy.

In this chapter, the validity of the ”reconstruction first”
and “stability first" arguments will be analyzed in the light of the
Korean economic situation and the optimal increase in money supply
‘will be estimated in order to evaluate the performance of credit

policy in Korea.

‘—__—_—._ - _ ‘_‘_-.h—___-
—r—

2A sharp increase in money supply was observed in 1958 largely
due to the absence of a ceiling imposed upon the aggregate money supply.
The Ministry of Finance states: "It allowed some flexibility to supply
apprOpriate funds for productive industries so that the deveIOpment of
industry would first increase production and then stabilize prices. This
plan emphasizes growth of production and price stabilit rather than the

volume of money supply itself.” See: W Seoul: Ministry
of Finance, 1959), p. 16.

3Similar observation is stated by Professor Bronfenbrenner;

"hny believe that there would be a reversion in the Japanese govern-
ment to policies associated with the name of‘Tanzan Ishibashi a self-
styled Keynesian ... recovery depends upon increased production. This
depends, in turn, upon capital accumulation, ... In financing capital
accumulation, taxes are to be kept low~while easy credit is ands avail-
able from a Reconstruction Finance Bank. The budget is to be unbalanced
deliberately.” See: Martin Bronfenbrenner, ”Pour Positions on Japanese

Finance”: Wm LVIII No.4. August 1950. pp-285-6-

w ——_—— — *F—w —— — ——

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161

o a c o

The magnitude of problems in Korea in relation to the avail-
ability of goods and services and ever-increasing demand is indeed
great. In terms of the Keynesian framework, ex ante investment
always exceeds saving. In terms of Harrod's model of economic
growth,4 voluntary saving does not adapt to the rate of capital
forution required to sustain _a steady expansion of production. Ihen
thriftiness is deficient, the ”warranted" rate of capital forntion
is less than the rate required by steady growth; thus, more invest-
ment spending will occur, causing further inflation.

In this situation, the correct policy should have been the
restriction of aggregate spending rather than the encouragement of it.
In Korea, however, the policy was expressed in terms of increasing
effective de-nd by printing excessive money (which will be shown
in section 6 of this chapter). Economic reconstruction is not a
matter of printing money. In such a situation, it is generally
agreed that the excessively printed money will reduce the level of
voluntary saving and divert productive investment into speculative
and high-profit economic activities, such as real estate, luxury
housing, hoards of foreign exchanges and precious metals. In
addition, the excessively printed money will create pressure on
foreign exchange reserves. lhen the degree of overprinting of money
is great, it will result in a cumulative inflation and the goals of

economic reconstruction will be defeated.

A___— __
——

A—‘fl ‘—

4Roy F. Harrod, ”An Essay in Dynamic Theory,” in W
New

W («L Hanson and Clo-Once
York: I. I. Norton, 1953 , pp. 22-219.

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Ca.

162
Therefore, Professor Ellis cautions about the dangers of inflation:
Indeed, the besetting danger of the monetary institution in
underdeveloped areas is inflation. The political atmosphere,
the aims of autarchy and-rapidity of development, the rational
distrust of domestic currencies, the absence of markets for
government securities, the “demonstration effect” of foreign
standards of living--all these produce a strongly inflationary
bias and inflationlms particularly pernicious effects on
development.5
It is imartant, then to study some factors which make the Korean
economy sensitive to inflationary forces. “Fundamentally, the main-
spring of the current urge to deve10p, the so-called 'great awakening,‘
originates on the demand side and operates through political channels."6
Korea's situation gave rise to important tendencies to increase aggre-
gate demand. There were two wars with their attendant war situation.7
The demonstration effect8 was particularly strong due to proximity to
United Nation forces. Population pressure was also imortant.
A crucial problem in this situation is the ever-growing demand
for money, especially when the government dominates in economic

activities as in Korea. The government demand for investment, not to
mention defense expenditures, does not seem to be related to the

availability of funds, but to the ability to create money.

_; —-_ *—-_“-~-.__— A‘ _
—_ — _ ___—_
—_ — i — ' v—i — i— w‘ ——

5Howard Ellis in a discussion with C. R. littlesey, ”Relation

of Ioney to Economic Growth.“ r c o v P e
2129;921:191. by. 1956. p- 207.
6K“ G. meller, e t a E Deve o
c a R f r e o Umublished Doctoral Dissertation,
University of Illinois, 1960 , p. 5.
7See Chapter II. "
8J. S. Duesenberry, me e o o C
M (New York: Prentice Hall, 1960), 27. See also R. Nurkse,
b e o I-' (New York:

 
  

Oxford University Press, 1960 , pp. 57-

 

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163

Despite all this, major problems of stability would not exist
if the Korean econo-y were able to increase real output in accordance
with the increasing aggregate demand. However, the capacity to in-
crease the supply of goods and services is very limited and is unable
to meet such ever-growing demand.

. o t r P o

A. Structural Undereqaloyment9

Economic factors such as the lack of capital equipment and
skilled labor are important conditions underlying structural un-
emloyment. As Professor Kindelberger states, ”structural unemloy-
ment results from lack of comlementsry resources or wrong factor
proportions, not from the dearth of effective demand."1° Provision
for productive equipment, skilled labor and entrepreneurs my help
solve the problem of structural unemloyment.

Structural unemloyment, however, is not due to economic
factors alone. It is also due to demographic and sociological
factors. Its distinctive feature lies in its massiveness and

chronic character which may be observed only in underdeveloped

9See footnote ll.

J”Charles Kindleberger, W (New York: rcGraw
Hill, 1958), p. 192.

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164

countries.11

In addition to this structural uneployment, the Korean

economy suffers from ”disguised unemloymsnt"12 and "uneqaloyment of

expansion."1:3

Structural unemloyment, disguised unemloyment and unemloy-
ment of expansion all interact with each other in such a way that the

unemloyment problem in Korea becomes cumlative. A nuwer of people,

A: A- A — —_ _—

———— w '——

“Joan Robinson's ”disguised unemloyment" has attracted
attention in academic circles. She states, “It is natural to
describe the adoption of inferior occupations by dismissed workers
as disguised une loyment.‘ Cf: her WW-
“ (2nd edition (Oxford: 8. Blackwell, 1947 , p. 62. Mrs.
Robinson's term may not be applied to structural unemloyment.
Disguised unelployment occurs primarily because of cyclical and
seasonal fluctuations, while structural unemloyment occurs at the
stage of transformation of a society from non-industrial to industrial
economy. when the process of transformation is slow due to economic,
sociological and edmographic reasons, chronic and massive unemloyment
will, in my opinion, occur independently from cyclical or seasonal
fluctuations. Structural undereaployment is characterized by the
existence of subsistence sector in which the marginal productivity
of labor is close to zero. There is a persistent gap of wages
between the two sectors of an economy.

12See footnote ll.

13Cf: Alfred Navarrete, Jr., 'and Ifingenia I. deNavarrete,
'Undereaploymsnt in Underdeveloped Countries.” Eco o is of
W (London: Oxford University Press, 1960;, p. 43,
They state: ”...is one which we shall call undereuploynent of
expansion, because it rises in time not of depression, but of
economic growth. It is due to the failure of capital and most
comlementary means of production to increase at the same rate as .
the supply of labor in secondary and tertiary activities. L This
type of underemaloymsnt is accentuated by deficit financing of
development programs and the resulting inflation, which intensi-
fies the cityward migration of agricultural workers and thereby

unduly swells the supply of labor in the face of a limited supply
of comlementary means of production.”

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165

'working on farms or small peasant plots, contribute virtually nothing
to output, but subsist on a share of their family's real income. In
technical terms, the marginal productivity of labor over a wide range
may be zero. '3 Arthur Lewis, in fact, clatms that the marginal pro-
ductivity of labor is actually negative.14

It is important to realize that these types of Korean unem-
ployment cannot be absorbed by means of expansion of monetary demand,
while disguised unemployment in industrially developed countries may
be absorbed by monetary expansion. When the monetary demand expands,
the result may be merely an inflation of prices.15

B. Inelasticity of Supply

In Korea, the transferability of factors from one use to

another is limited.‘ In addition, there seems to be a series of

_—_.— — — #w —-_‘ _ _— _

__ w i— — — ———

14'. Arthur Lewis, ”Economic Development‘with.Un1imited

Supplies of Labor.“ e Eco c 0 U ere o , p. 402.
Also see Benjamin Higgins' W New York: I. I.

Norton & Co., 1959), p. 242. Jacob Viner argues against the negative
productivity of labor. See “Some Reflections on the Concept of
'Disguised Unemployment," tr u s A a e xe o

Economico (Rio de Janeiro, 1957 , p. 347. Viner states further:
“Even supposing that there*were such a farm on which every product
had technically and economically fixed ingredients, labor would

still have positive marginal productivity unless there were not only
fixed technical coefficients of production for all the economically
relevant potential products of the farms, but the prOportions between
the technical coefficients were uniform for all of these products.”

15a. Mrkse, my, p. 17. A study made by the United
nations points out: “The fact that the investment result in in-
creased production in the future is no assurance that the creation
of bank credit to finance deveIOpment will not rise to inflation
now. The argument for this policy is based on a mistaken analogy
between underempliynent in underdeveIOped countries and unemployment
in industrial countries." Cf: Bernstein, Gooded, Friedberg, and
Patal, ”Economic Development with Stability," in Staff Papers (Vol.
III), pp, 313-386.

166
bottlenecks in the process ofproduction of most important commod-
ities. Non-transferability of factors and bottleneck situtaions make
the aggregate supply curve very inelastic: thus, the Korean economy
is especially vulnerable to inflationary forces.

For instance, amplitudes of agricultural price fluctuations
are much larger than those of industrial price fluctuations due to
inelastic supply and demand curves of farm products. Especially,
supply is almost perfectly inelastic in the short-run. Any varia-
tion in demand, therefore, simply pushes up the price of agricul-
tural products. Sixty to sixty-five per cent of the total labor
force engages in farming and produces about forty to forty-five per
cent of total national output. Thus, the variation in price of
agricultural products has a great impact Upon the general price
level. That is, the variation of agricultural product prices
accentuates the oscillations around the secular trend of prices.

The supply of industrial products is less inelastic than
that of agricultural products. The elasticity of the supply curve
of industrial products, however, seems far less than in industrial
countries.

When industries are well-structured, as in a deve10ped
country, an increase of sUpply of a particular commodity will be
made without establishing an additional industry, which is essential
for the production of the particular commodity. When industries
are sparsely-structured as in Korea, however, an increase of supply

of a particular commodity may require the enlargement of the new

 

II. I‘il EJ-

167
establishment of a certain industry. The elasticity of the SUpply
curve is, therefore, more likely to be less in Korea. Scarcity of
basic factors of production, such as power, capital equipment,
working capital, and essential raw materials, is acute in Korea.
A rapid expansion of monetary demand, therefore, can at best increase
production up to the point where the scarcest factors will be fully
employed. Beyond this point, the monetary demand‘will simply cause
inflationary spiraling.

It should be mentioned also that there are few factors which
dampen Korean inflation. Automatic stabilizers, such as progressive
taxes and social security systems, dampen inflationary forces in
developed countries. However, the Korean tax system, as in many
other underdeveloped countries,16 seems so inelastic that the govern-
ment cannot count on yields of taxes rising substantially'with prices
or impose an ”automatic stabilizer” effect.

C. Price Structure

In addition, the market in Korea is imperfect. Except in
urban areas, the “Jam," a traditional urket which comines barter
trade and some money exchange, is a predominant market pattern. The

'Jang' is characterized by inelastic demand and supply: thus, the

— *Ah #_—_ 4+ —— ——— —

— ww ———'—f w

16United Nations Economic Commission for Asia and the Far East.

n ' b 1 ion f Do Ca t (Bank Kek: October 22,
1951 , p. 6. It seems that the tax structure of Korea became more
regressive to heavier recourse of the government revenues upon direct
tax imposition. The higher the marginal propensity to pay taxes and
save and the less the inelasticity of price expectations, the greater
the possibility of continuous deficity financing for capital for-
mation. See also: Kindleberger, C., on, git., pp. 193-194.

/

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168
price level varies greatly with a small change in demand and supply.
Only in urban areas does the market in the modern sense exist. This
modern type of market, where money is the transaction medium, is a
conglomeration of controlledl'7 and highly sensitive free-market
prices.

Prices in the free market are wch higher than those in the
controlled market. Controlled prices are set below the cost of '
production with the hope that this will contribute to an anti-
inflationary effect. Certainly, the controlled price policy will
contribute to an anti-inflationary effect if it operates well.
Inefficient nnagement of controlled prices in Korea, however,
seems to contribute to inflationary forces. Virtually all of the
industries under the controlled price policy Operate at a loss.

The deficits are usually offset by government subsidies or loans
from the banking system. Loans are usually made through political
pressure and are essentially equivalent to subsidies because few
loans are paid back comletely. Due to the fact that deficits can
be met by subsidies or loans, the pressure for efficiency imosed
by the market is iapaired. An alternative to improved efficiency
in order to minimize losses is that of receiving subsidies or loans.

When receipts of subsidies or loans do exceed the losses actually

!— —— __
— _, www —f '— w—— t —-

17"In the monopoly industries, including the important trans-
portation, comnications, and power industries, prices and wage rates
are established by the National Assemly. In other industries, direct
control of prices and wages is largely limited to the vested companies,
which are administered by various ROK ministries.” UNKRA, Ag Ecgnoflg

_W (New York: 0.11.. 1954). p. 185.

 

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169

incurred, the differences are invested in the free-market sector.18
This‘will bid up the prices in the free market, thus contributing an
inflationary effect.

A particularly important phenomenon is the rigidity of the
price structure due to controlled prices and the imperfect market
structure. ‘Nhen prices are rigid downward in one sector, and sens-
itive upward in the other, a rise in prices in the sensitive sector
‘will raise the prices in the other sector. Prices of other sector
will set a higher floor of prices and bring forth further pressure
for price increase in the sensitive sector.

4 e e e P a o no es s

Observations in the previous sections point to the fact that
the Korean economy is very sensitive to inflationary forces. Reasons
include structural problems and some man-made problems like using the
wrong monetary policy and managing price policy inefficiently. Above
all, economic reconstruction is not a matter of printing money.
Though the Korean economy possesses some idle capacity19 and is
different frqm other underdeveloped countries which are initiating
economic development in the sense that Korea has a skeleton of in-

dustries, a sharp increase in aggregate demand is not the solution

18There are evidences that such funds flow into the indigenous
money market, called 'Kei,” or into speculative business. See: I. D.
Nettles, k 0 u K e . (Unpublished thesis, University
of Oregon, 1961 , p. 7.

19For example, the level of industrial production in 1945 was
about 50 per cent of that of 1939. In 1954, a level equivalent to the
1949 level was reached.

‘i—u —

 

 

mole-d

170

for economic reconstruction. Economically, stability arguments
appear to be more logical because no sound and durable reconstruction
can be expected until the economy has been stabilized to reduce the
risk involved in economic calculations to a manageable size. The
fact that money was supplied in excess of the increase in real out-
put indicates that it was undoubtedly an imortant cause of inflation
in Korea in the last fifteen years. Therefore, monetary policy in
Korea should have emphasized price stability. This argument, however,
is different from that of the conventional argument of price stability.
Traditionally, the stability argument emerges from the problems
of business cycles. Objectives of monetary policy, therefore, have
been counter-cyclical in content based on a deep-seated belief that an
appropriate monetary policy could eliminate the fluctuations in eco-
nomic activities.20 It is correct to say that goals of monetary
policy, in this case, lack the notion of economic growth. The role
of monetary policy in the conventional argument assumes, at best, a
passive nature in the context of economic development. As Professor
Ellis indicates, "monetary policy makes its IXIIJI contribution to
economic growth and to the balance of that growth if it succeeds in
keeping prices reasonably constant and emloyment reasonably full."21

On the other hand, Professor lhittlesey challenged the concept

__ _.__ ‘__ _ —-._ A; __ ___._. h

————~_w———f — w

20J. I. Angell, ”General Objectives of Ionetary Policy“ in Ill!

Wm. at. Arthur D. Gayer (New York: Farrar
& Rinehart, Inc., 1937 , p. 53.

21Howard S. Ellis, in the discussion with lhittlesey, M"

p. 207.

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171

of price stability as follows:

One cannot hypothesize that with stable price a higher level

and a more even rate of growth would have been achieved in

this country than actually were attained, but any such con-

clusion mst renin uncertain. I have always found the

argument persuasive that wildcat banking my have contributed

to the more rapid development of the West by providing a

cheaper forl of circulating wediun than specie, by the

stimulus to production and the effect of redistribution of

incone that may have resulted, and perhaps in still other

"Y‘e

Wildcat banking is not to be reconended in Korea. However,
the hypothesis that a higher level or even faster rate of reconstruction
could have been achieved with stable prices nay be invalid. An
emirical study of other countries also suggests no systenatic
relationship between price change and rate of econonic growth.2’3

The achieve-ent of price stability, as considered by proponents
of price stability, is to pro-ote growth as a byproduct.24 The factors
which make an econowy grow are the real factors, such as technology,
capital, natural resources, human capital, and many others. Granting
the imortance of the real factors, it still should be said that con-
ventional monetary analysis is unduly centered in the problews of
value or price level, noney being only a non-co-ittal spirit in the
process of economic growth. The monetary analysis should be centered

in the econowic process as a whole in which noney will act positively.

__ #-—-
— *‘fi'wt w—vw‘ —

23Rattan J. Bhatia, “Inflation, Deflation, and Econo-ic
Develop-ent," in W (Noveioer, 1960), p. 102.
24

C. Kindleberger, M" p. 189.

172

How could positive monetary policy contribute to economic
growth? For an economy to grow, it requires specifically (1) additional
investment to generate new output and (2) increasing themarginal rate
of saving so that a larger proportion of the increasing income may be
devoted to further capital formation.” These requirement, however,
are very difficult to carry out in Korea without the positive role of
monetary policy, unless investment occurs without the reduction of
consumtion by sons external sources. An additional investment to be
carried out by an innovator in the Schumeterian systen is associated
with bank credit,26 which is an essential ole-ent of economic growth.
The amount of investment which can be undertaken by an entrepreneur
in Kaldor's model depends upon the possibility of earning profit,
which in turn depends upon deficiency or sufficiency of money avail-
able in an economy. It should be noted that the crucial issue in
economic development in Korea is the deficiency of voluntary saving
to meet the demand for funds for productive investment.

Honey can make positive contributions to economic growth.

For example, slight inflation, if it comes in the process of capital
fornation, will increase forced saving. Slight inflation may also be
used as a substitute for taxation, especially when the taxation is

unpopular. Investment can be increased in the case of inflation

——_—— — ‘—

2511. G. holler, M” p. 31.

26.? oseph a Schumeter, Ihe mean 9f Ecggggg Dgelmgt,
translated by Redvers Opie (New York: Oxford University Press, 1961),
PP. 95-127e

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173

through lowering the real rate of interest. The money rate is
normally equal to real rate plus some percentage of price change.
lhen prices increase faster than the money rate, the user of funds
is paying a negative rate of interest. Referring to the growth of
the British economy since 1946, Kaldor mentions, ”this is precisely
what the inflation had done; it reduced the real rate of interest to
negative levels throughout most of the period, and to around zero
during the recent period of relatively high interest rate."27
Professor Bronfenbrenner, in fact, suggests an “optimm degree of
inflation"28 and indicates the usefulness of slight inflation at the
early stage of econowic development. He suggests that it my permit
the authorities to raise the relative price of the types of labor
and capital goods required for deveIOpment projects without imosing
on other sectors of the economy the reductions in money wages and
prices which would otherwise be required. lore imortant is Bronfen-

.29

brenner's “money illusion argument, which states that, in its

early stage, a slow inflation or even a rapid one induces laborers
to work nore intensively for real income which is no higher and which
may be lower than their previous level. Therefore, 'it seems to be

imossible to hypothesize that money is passive and that maxim:-

-——— _—__— — _#_ __—__‘_4—_ _

— i

2Tllicholas Kaldor, "Economic Growth and the Problen of
Inflation,“ 1am (August, 1959), p. 289.

28hrtin Bronfenbrenner, "The High Cost of Economic
Development,” inW (August, 1953): P-210-

29hrtin Bronfenbrenner, 11311., p. 210.

I.

174
growth can be achieved with stable price.
The role of monetary policy should be, therefore, defined

positively. Not only the mnintenance of price stability but also

 

slight inflation should be the goal of monetary policy. Since in- g

flatien is not homogeneous by any means, it refers here to profit I:
inflation. How'slight should the inflation be? An answer to this I
question depends upon institutional circumstances. Hanover, this
is an issue about which no affirmative statement can be made on
empirical grounds. For this reason, a pragmatic approach is inevit-
able in the matter of policy. That is to say, the Bank of Korea will
increase money supply in such a way that price level changes within
a reasonable range. To achieve this purpose, the Bank perhaps*will
have to set the maintenance of price stability as the goal of
monetary policy with some allowance for additional increase of
money supply depending upon business conditions.

I... "in. . ,,|. '» q. .‘ . 1_..

In estimating the optimum pattern or the optimal increase in
money supply, Professor Bronfenbrenner's work30 has been invaluable.
The optimal increase in money supply, as it is used here, essentially
means the "safe” rate of increase in money supply, which in turn is
defined as just the rate of increase which would not contribute to
inflation. More discussion about this issue is made later. The

Optimum pattern of money sUpply will be estimated for the last fifteen

‘___ _
7”
v.— —— w—vr U

30!. Bronfenbrenner, ”Statistical Tests for Rival lonetary

Rules” in til-WW (February. 1961). pp. 1'7.

 

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175
yoars in tho hops that tho pattorn will givo us a critorion upon which
tho porfornnnco of tho Bank of Koroa nay bo ovaluatod.

Though tho arqunont of “what should hays boon’ has inportant
historical noaning, tho ostination is nocossarily crudo and nny
signify only an oxplorativo valuo. [Spocifically, tho optinnl
incroaso in nonoy supply is ostinntod on tho basis of tho actual or
on post bohavior of volocity. Tho actual bohavior of volocity would
chango in tho absonco of inflation. In ordor to ostinsto tho optim-
pattorn of nonoy supply, no lust know tho bohavior of volocity in tho
absonco of inflation. Bocauso volocity is unknonn in poriods'nith-
out inflation, tho diffsronco botnoon tho incroaso in tho anount of
Ionoy supply and tho optinnl incroaso in nonoy supply is only an
indication of tho doparturo of tho mm fro- tho W
on tho assunption that tho difforonco in policy would havo no offoct
on tho curront volocity of circulation.

Tho prinary concorn of tho contra! bank policy is to naintain
tho optinnl incroaso in nonoy supply. Thoroforo, a logitinnto
quostion soons to ho ”to what oxtont dotho changos in nonoy supply
affoct tho bohavior of volocity?‘ Alt is shonn in Soction C, Chaptor
B, Appondix, that thoro doos not soon to bo any ovidonco of a dopon-
dont rolationship botnoon nonoy supply and tho socular bohavior of
volocity. This loans that thoro is no ovidonco that a difforonco in
tho control bank policy would affoct tho bohavior of volocity.

Tho statistical ovidonco prosontod in tho Appondix, honovor,
is only tontativo rather than affirnntivo. For this roason, thoro
should bo sons allowanco for a dopondont rolationship botnoon nonoy

supply and tho bohavior of volocity in tho intorprotation of tho

' F R ~n n “" -
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In)

176

optinol incroaso in nonoy supply.

Tho fornula usod in ostinoting tho optimn pattorn of nonoy
supply in this soction is basod on tho critorion of nointaining prico
stability. This appoars to bo inconsistont with what has boon said
in tho provious soction bocauso slight inflation conducivo to oconolic
roconstruction was accoptod as tho goal of nonotary policy.

According to tho dofinod goal of nonotary policy, nonoy por-
forns two functions. Ono is to acco—odato tho crodits which aro
nocossary to noot tho incroaso in roal output; that is, tho incroasod
nonoy supply should be procisoly oqual to tho incroaso in roal output.
An additional function is to incroaso nonoy supply slightly noro than
tho rato of rool output in ordor to induco ocononic growth. Ihon ox
post data on tho rato of roal output aro givon, it is inpossiblo to
distinguish botwoon tho output which incroasod duo to roal factors
and tho output which was inducod by additional nonoy supply. loro-
ovor, data for roal output aro not availablo in Koroa.

Thoorotically, it is possiblo to ostiloto tho optimn pattorn
of nonoy supply only whon tho two ratos of roal output abovo nontionod
aro known. Sinco it is not possiblo to ostinoto thoso statistically,
tho optimn pattorn of nonoy supply is ostinotod on tho basis of tho
rato of incroaso in nonoy supply which would havo nintoinod tho
stability of tho prico indor as an approxinotion. This is partly
duo to pragnotic roasons and partly to statistical difficultios.

In dotornining tho optima pattorn of nonoy supply, duo con-
sidoration should bo givon to tho fact that tho dot-Ind for nonoy for

hoarding erosos, or tho divorsifiod donond for nonoy, will nocossarily

.“I' H? 'Pnon n2 eerodani leaf; 0

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177
incroaso as surplus units of tho ocono-y accumlato financial assots.
In addition, a far noro imortant considoration in tho caso of Koroo
is tho additional nonoy supply which will bocono nocossary as tho
nonoy soctor of tho oconony oxpands.

A thoorotical ground for tho ostintion of tho safo rato of
nonoy supply can bo boot oxplainod by roforring to tho Fishorian
oquation of tho quantity thoory, with sons nodifications, which is
oxprossod as:

we I PI (1)

P.....Indox of Avorogo Dononination
T.....loasuro of Roal National Incowo
I.....Total Ionoy Supply as dofinod in Chaptor V
V.....Incono Volocity of Ionoy

Tho ‘oquation can bo oxprossod in a difforontiol forn as:

.‘LE/Q'U/u
w v p T

h In an idool situation in which tho prico lovol is stablo, d?
boconos zoro. lith a givon rato of chango in tho nonoy supply and
constant volocity, tho chango in pricos will bo zoro whon tho roal
output incroasos noro than tho rato of nonoy supply, tho prico lovol
will doclino, or ronoin constant whon tho chango in volocity offsots
tho difforonco botwoon tho rats of chango in tho nonoy supply and
that of roal output. Thus, it is possiblo to dofino tho optimn
pattorn of nonoy supply, (dl/l)” as follows:

(11):!1'“ (2)
lo T V

This noans thot tho safo rato of incroaso in nonoy supply is oqual to

tho roto of chango of roal output ninus tho rato of chango in volocity.

 

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178

lhon d? is not zoro, tho actual rato of chango in tho nonoy supply

would bo:

u-n-u+u 4(3)
I T V P

lhon Koynos says, ”Tho sun of tho olasticitios of prico and
output in rosponso to changos in offoctivo donond is oqual to unity,'!31
ho soons to rofor to tho contontion of tho abovo oquation. Tho offoc-
tivo donond sponds itsolf portly in affocting output and portly in
affocting prico.

Bron oquations (2) and (3) tho optima: pattorn of nonoy supply
can bo dorivod as:

(LI)- LU - LE (4)
n n P .

Tho vorbal intorprotation of oquation (4) suggosts that any incroaso
in nonoy supply hyond tho optimn rato will bo rofloctod in tho
gonorol prico lovol.

Tho linitation of this formula in doriving tho optimn pattorn
of nonoy supply is tho fact that it is basod on a difforontiol formla.
That is, tho usago of tho difforontiol for-11a is valid only whon
changos in variablos aro s-ll. Howovor, both tho indox of nonoy supply
and prico in Koroa havo changod groatly and discontinuously. In ordor
to olininato tho imct of tho discontinuous changos, tho following
formula is usod for tho purposo of connotation:

313- I- Kmm. W
m (low York: Harcourt, Braco Co., 1956 , p. 285.

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179

 

‘ 3,2
L LN

(AM) -.: 1+ M - l (5)

M O Ll*AP

P
6. The Estimation of the Optimum Pattern of Money_Supply
Column 3 of Table 17 shows the optimal increase in the money

supply which is based on the index of average denomination of currency.
Column 6 shows the Optimal increase in the money supply based on Seoul
Wholesale Price Index. Both columns indicate that the actual increase in

the money supply is greater than the indeal patterns. This may lead to

the hypothesis that the Bank of Korea increased the money supply

 

32The Fisherian equation can be expressed as follow:

(M+AM)(V+AV) = (P+AP)(T+AT) (a)
(M+AMDO(V+AV) = (p)(T-rAT) (b)

( M+AM ) ... the actual money supply
( M+AM )o the optimal money supply

From equations (a) and (b),

 

 

 

 

 

 

(M+AM) = (M‘tAM )0
P 4P5‘P P
M:
(1+€;L},.= i+aM¢_
. 0 2.2.
1+ 43
' AM _ 1+A-E-
Io M — ... I ...CC")

 

180

oxcossivoly ovor tho last fiftoon yoars.

As Iontionod in tho provious soction, tho optima pattorn of
nonoy supply is ostinatod on tho basis of tho actual bohavior of
volooity on tho assumtion that tho difforonco in policy of tho con-
tral bank would havo no offoct on tho bohavior of volocity. If tho
volocity of circulation is indopondont of changos in money supply,
tho abovo hypothosis will hold truo. Although thoro is no ovidonco
of a dopondont rolationship botwoon nonoy supply and changos in
volocity, as prosontod in tho Appondix, thoro nay still ho a possi-
bility that volocity would bohavo difforontly with tho changos in
nonoy supply. If thoro is a volocity chango, it is nocossary to
aka an adjust-ant on tho intorprotation of tho optimn pattorn of
money supply.

To aka a caroful intorprotation of tho ostinatod optima:
pattorn of nonoy supply, lot us assume that volocity changos as
tho nonoy supply incroasos, as indicatod in colums 3 and 6. Tho
volocity may go oithor up or down as wonoy supply changos. If
volocity risos, tho osti-atod optima nonoy supply, indicatod by
columns 3 and 6, would bo too largo for tho idoal pattorn. An in-
croaso in yolocity will aug-ont tho difforonco botwoon tho actual
nonoy supply and tho idoal patterns of nonoy supply boyond tho
figuros shown in colours 3 and 6. Thoroforo, an incroaso in volocity
strongthons tho procoding hypothosis.

If volocity woro to doclino, tho figuros prosontod in colums

3 and 6 would ho lowor than tho idoal pattorn. For this roason,

q

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181
TABLE 15#
YEAR TO YEAR PERCENTAGE CHAKSBS IN PRICES, DIET, OPT IIJII RATES OF
DNEY SJPPLY AT CONSTANT mm Al) EXCESSIVE RATE OF DNEY SUPPLY

 

 

 

 

_ ' 6 6 '
__. 1.111 iJHL, o __

1946 64 .38 27 . 1 1 29 .32 49 .32 476 . 52 -71 .49 -51 .49

1947 104.17 67.28 22.05 42.05 59.92 27.67 47.67

1948 65.56 39.83 18.40 38.40 59.62 3.72 23.72

1949 59.49 17.28 36.10 56.10 36.32 16.99 36.99

1950 71.37 88.78 -9.23 10.77 118.35 -21.52 -1.52

1951 231.76 268.69 -10.02 9.98 316.06 -20.27 -.27

1952 89.90 44.19 31.70 51.70 141.72 -21.44 -l.44

1953** 105.19 389.47 -58.08 21.50 68.88

1954** 117.05 5.14 106.43 29.98 67.98

1955 53.52 115.24 ~28.68 -8.68 79.88 -l4.66 5.34

1956 41.64 20.88 17.17 27.17 35.39 4.61 24.61

1957 23.11 26.89 -2.98 17.02 12.85 9.09 29.09*
1958 28.39 4.14 23.28 43.28* -5.67 36.10 56.10*
1959 26.96 25.01 1.55 21.55 12.77 12.58 32.58*
1960 .01 44.20 -30.65 -10.65 10.58 -9.56 10.44*

'7'.— _—

h ...... X change in actual money supply

Pn ...... X change in tho index of average denomination

(ho) ... X change in tho optimn rate of money supply
colputod on tho basis of index of average
denouination

Pw ...... X change in the index of Seoul lholesale prices

(Ito) ... X change of tho optimn rate of wonoy supply
colputed on the basis of the Seoul lholesale
Price Index

3 The coQutation is based on annual average figures.
** The years of 1953 and 1954 are excluded because of tho imact of
currency roforn.

‘1.-.”

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182

Coluans 3' and 6' are estiaated on the assuaption that velocity declines
20 per cent. Let us call these coluans the andified-ideal patterns of
aoney supply. Coluan 3‘ indicates that the actual increase in tho aoney
supply is greater than the aodifiod-ideal increasowwith the exception of
1958. Coluan 6' indicates that the actual increase in the aoney supply
is greater than the aodified ideal increase with exception of 1957, 1958,
1959 and 1960. With the exception of a few years, then, the both aodi-
fied-ideal patterns of aoney supply also indicate that the Bank of
Korea failed to aaintain the Optima pattern of aoney supply. The Bank
increased the aoney supply excessively.

The years 1957, 1958, 1959 and 1960 are the exception to the
above conclusion. In other words, the Bank aight not have increased
the aoney supply excessively. This is true only with the assuaption
of a 20 per cent decline in velocity'which would be accoapanied by the
increase in the aoney supply as indicated by Coluans 3 and 6. Suppose
that this assumtion is not realistic in the light of the econoaic
conditions prevailing then. Then the arguaont that the Bank did not
increase the excessive aoney supply becoaos dubious. This assumtion
of the 20 per cent decline in velocity in 1959 and 1960 is unrealistic
when viewed with its past behavior. Except for 1957 and 1958, there
seeas to be a clear indication of an increase in velocity. For
exaaple, the deaand deposit velocity increased in 1959 and especially
1960, when the political situation was unstable. Would the increase
in the aoney supply indicated by Coluans 3 and 6 cause velocity to
decline? It is unlikely. Therefore, the argument that the Bank
adght not have increased the aoney supply excessively in 1959 and

1960 does not seea true.

 

r1

1“

183

Even a 30 per cent decline in velocity would result in about
the saae situation aentioned above. The comarison of the optiaua
patterns of aoney supply indicated in Colums 3, 3', 6 and 6' thoro-
fore clearly suggests that the Bank of Korea increased the aoney
supply excessively over the whole period of this study.

If real output were to increase with the increase in the
aoney supply as indicated by Coluans 3 and 6, the above contention
is weakened. The possibility of an increase in real output with a
less increase in the aoney supply is very slia. This, then, strength-
ens the above contention that the Bank of Korea increased the aoney
supply excessively.

Over the whole period of years, the average of annual increase
in the optima aoney supply is 7.5 per cent according to the index of
average denoaination. This rather high value does not seea unreal-
istic in the Korean situation. A possible explanation is as follows:

A. The rate of real output must have been greater than

that of other countries, because Korea has possessed
soae idle capacity since her liberation.

B. The foreign assistance prograa provided real goods

annually, equivalent to $250,000,000 since the war.

C. During the last fifteen years, there has been a

rather rapid expansion of the aoney sector of tho
econoay. The expansion of the aoney sector Inst

have required an additional aoney supply.

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184
D. Existence of the subsistence sector, from which the
government could transfer a large amount of real

90d"33

provided a buffer for additional money
supply in the money sector without affecting the
general level of prices.

E. Iago rates in Korea have, in general, lagged behind

the movement of the general price level.

P. Reconstruction is easier than development.

According to the index of Seoul Iholesale prices, however,
the Optimum rate of money supply shows a 3.7 per cent decline annu-
ally. In view of the situation described above, the reduction of
money supply does not seen realistic at all.
LWW

Table 16 presents the optimum change in the annual money
supply, actual change of money supply and the annual change of
mOney supply attributed to the public sector, private sector,
foreign sector and others. The public sector includes a wide range
of imortant econoaic activities. The annual change in money supply
attributed to the public sector is derived by subtracting govern-
ment deposits and the counterpart fund deposits at the Bank of Korea
from the sum of government overdrafts, advances to the United Nation
military authorities, national .bonds, industrial debentures held at

the Bank of Korea and loans made by the banking system to government

335. P. Schatz, “Inflation in Underdeveloped Areas,“ m

Win. Sept-lb». 1957. p. 582.

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185

agencies and local governments.

The annual change of the money supply attributed to the
private sector is derived by subtracting the time and saving deposits
from the sum of loans made by the banking system to the private
sector. The foreign sector change is silply the difference between
the Bank of Korea purchase of foreign exchange and the deposits of
foreign organizations. The 'other' sector comrises chiefly the
interbank accounts of individual banking institutions and uncleared
checks and drafts.

Over the whole period of this study, the annual expansion of
money supply attributed to the public sector alone has been in excess
of the optimm annual change of money supply. An obvious inference is
that the government sector has been prinarily responsible for persist-
ent money supply expansion and, thus, for the continuous inflation
during the period of study. The slowdown in the pace of inflation
aux! relatively stable prices from 1956 until l959were largely due
to the strengthened government budgetary position and also then to the
rigorous enforcement of the over all Financial Stabilization Program
since 1957. The rapid increase in the price level in 1960 is once
again largely due to the credit expansion attributed to the govern-
ment sector. .

Despite the huge increase in bank credit underlying the
expansion of money supply, attemts at credit control have been
ineffective. Clearly, the Bank of Korea was not in a position to

restrict overdrafts by the government. The Bank was also not in a

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186

position to restrict loans to the government agencies and local
governments. since such loans were predominantly for the purpose of
government-sponsored undertakings. Yet the answer to the price
stability problem should be found. An obvious solution lies in
restriction of government spending within the limit of the optimm
pattern of money supply assuming no alternative means of finance.
lhen the government expands credit within the limits of such
optimam pattern of money supply, the Bank of Korea should attemt
to sterilize the subsequent increase of colmercial banks' reserves
by requiring 100 per cent reserve requirements on the subsequent
increase in the deposits at the commercial banks.

When credit expansion attributed to the government sector
exceeds the optimum rate of money supply, not only the sterilization
of subsequent increases of coemercial banks' reserves, but also the
contraction of an equivalent annunt of credit in the private sector
is required. This requires-ht is necessary not only for maintaining
price stability, but also for achieving the diversion of resources
from the private sector to the government sector. In Korea,
inflationary pressure has been emanated/Egsmaccentuated By m
attempts of the government sector to secure a larger share of the
total output. lhen the private sector reacts against such attelpts,
a failure of the planned diversion of resources results. This failure
requires a nuch bigger attempt of diversion by the government in the
next round, creating a further spiral of inflation.

Clearly, then, the Bank of Korea should have reduced the

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187

equivalent amounts of credits in the private sector in order to
achieve the goal of monetary policy; lhether or not the Bank of
Korea reduced the credit available in the private sector, therefore,
provides a criteria for evaluating the performance of the central
bank in Korea.

Assuming the foreign and other sectors of the economy
remain neutral in the expansion of the money supply, a look at the
column of the private sector clearly indicates that the changes in
money supply attributed to the private sector also reinforce the
argument that the Bank of Korea increased the money supply excessively.

A. Policies for Credit Control

A njor form of credit control before the establishment of
the Bank of Korea was the requirement of prior approval by the govern-
ment for all loans to the private sector and the government agencies
in excess of certain specified amounts. In December, 1945, for
examle, the military government issued a directive that prohibited
banks from nking loans to any one party in excess of 100,000 won
without prior approval of the Department of Finance. This limit was
raised to 500,000*won in August, 1947. In April, 1949, the limits
were further raised to 2 million won by the Korean government.
Bloomfield states, however, that relatively few loans in excess
of the limit were rejected by the authorities. Under the adminis-
tration of the Republic of Korea, moreover, it appeared that

political rather than economic consideration dictated the rejection

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189

of such loans as were not approved.34

A series of directives which stipulated the restriction of
undesirable loans, loan renewal and loan collections were also issued
from time to time. The authorities also raised the maxium rates of
interest that could be charged on the various categories of bank loans.
However, such credit policies, as a whole, were far too weak to curb
the rapidly increasing credit expansion. Practically all the banking
institutions were owned and controlled by the government after the
liberation. Monetary institutions were primerily engaged in financing
government expenditures. Therefore, the banking reform was an urgent
and essential measure for mintaining the stability of the Korean
economy. The banking reform was initiated by the establishment of
the Bank of Korea, as described in Chapter III.

During the Korean lar period, there was no need for credit
control over conercial banks. All of the conercial banks exhausted
the resources for bank operations after the 'run" on deposits from
the banking system. lith the establishment of more settled economic
conditions and the restoration of banking facilities late in 1951,
however, strong measures of credit control were initiated. These
strong measures were necessary because a sharp increase in bank
loans to the private sector and government agencies were observed
during 1951. ' The Bank of Korea raised the meximm rates of interest

that co-ercial banks could charge for various categories of loans;

—V'-'v

3“A. I. Bloomfield and J. P. Jensen, 8 Re 0 'u h
m (New York: Federal Reserve Bank of New York, 19515, p. 40.

 

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190
anximum maturities were imposed on certain categories; a reserve
requirement of 10 per cent was imosed on deposits at the co-ercial
banks. All loan applications to commercial banks in excess of 50
million won were required to be approved by the lonetary Board.
The Board also set up a list of priorities bwahich commercial banks
were to grant loans.

Since then, the Bank of Korea has implemented a variety of
credit control measures. As explained in Chapter IV, the conventional
tools of credit control are unworkable and ineffective'when used in
Korea. The tools that the Bank of Korea has heavily relied upon have
been the selective control measures. By and large, the direct measures
of credit control in terms of quantitative and qualitative measures
have been used extensively. The most important tool has been the
loan ceiling policy. For this reason, success or failure of the
Bank of Korea in restraining credit expansion can be Judged by
whether or not the loan ceiling policy has succeeded in restraining
credit expansion. Therefore, the study of the loan ceiling policy
is important.

B. Loan Ceiling Policy

Loans made by commercial banks declined from 63 per cent in
1953, to 30 per cent in 1960. Of the total loans made by the Korean
Reconstruction Bank, the Agricultural Bank and commercial banks, as
already indicated, many of the loans made by the banking system
‘were outside the control of the Bank of Korea and the ceiling was

not applied to existing commercial bank loans. Further, the loan

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191
ceiling policy was not applied to special categories of transactions
which were defined by the Monetary Board, including, among others, loans
for iaporting materials for production activities and national defense.
Therefore, the loan ceiling policy, here, applies to only a small
portion of total funds available in the economy.
The use of the loan ceiling policy was first initiated in
my, 1950, before the establishment of the Bank of Korea, through
the suggestion of Bloomfield. The Ilinistry of Finance placed a
celing on the expansion of loans by conercial banks to private
borrowers in each quarter. The ceiling for the next quarter was
suggested by Bloowfield as not to exceed nore than 5 per cent above
the amount outstanding at the end of the preceeding quarter.
Allegedly stronger ceiling policy was then imle-ented in
1951 together with various leasures of vigorous credit control. The
Ionstary Board imosed an over-all ceiling on the expansion of con-
nercial banks as follows:35
2nd quarter, 1951 .... 17.7 billion won
3rd quarter, 1951 .... 32.2 billion won

4th quarter, 1951 eeee 57oz billion "a
1st quarter, 1952 .... 16.0 billion won

123.1 billion won
The result of this loan ceiling policy was sadly disappoint-
ing. The expansion of bank credits during this period was far nore

than planned, about 193 billion won. An obvious reason for the

*1 —__ W

35a. 1. Moon-field. W
W (Seoul: Bank of Korea, 1952 , p. 13.

 

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192

failure of the loan ceiling policy is the fact that the ceiling
on the next expansion of bank credit for each quarter was set too
high. It should be noted that the expansion of bank credit to the
public sector alone exceeded the safe rate of increase in money supply
during this period. In view of this fact, the original plan for the
loan ceiling was not an appropriate one.

Technically, the management of the loan ceiling policy'was
wrong. One reason is that the high ceiling*was fixed on the basis
of expected growth of deposits, as Bloomfield clearly pointed out.36
The ceiling fixed on the basis of expected grewth of deposits
certainly evaded the very purpose of the ceiling policy, because
the ceiling policy should aim at the restriction ofsecondary expan-
sion of credit which results from the primary expansion of bank
credit. (The practice of establishing the loan ceiling on the basis
of expected growth of deposits was discontinued in September, 1952.)
Another reason is that the Bank of Korea Imde»loans to commercial
banks totaling more than 71 billionwwon during 1951. The very fact
that the Bank of Korea ande'loans to commercial banks defeated the
purpose of imposing the ceiling on net expansion of bank credit.

Credit control measures, in general including loan ceiling
policy, were very tight in 1952. However, in view of the fact that
bank credit greatly expanded to the public sector and that bank

credit continued to expand even tothe private sector despite the

 

‘———_—— —— ~_

3631mmfield, mm, pp. 13-15.

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193
allegedly tight measures of credit control, the credit policy as
a whole failed in restraining the expansion of the money supply.
Therefore, the currency reform of 1953 was designed to overhaul
the currency and credit condition.

After:the currency reform, the credit condition in the
private sector was very tight. In the meantime, government expend-
itures increased rapidly. Because of this tightness of credit in
the private sector, the measures of credit control became very lax.
For example, reserve requirements and bank rates were lowered. At
the same time, the specific loan ceiling which had been imosed
upon each individual bank was removed.

The consequence of this removal of loan ceiling can be
assessed only on the basis of incosplete information. It is noted
that 1954 was once again a year in which bank credit to the public
sector increased in a wholesale fashion, as is shown in Tables 8
and 16. In addition, the loans of the Agricultural Bank increased
and the establishment of the Korean Reconstruction Bank added fuel
to the inflationary pressures. Despite these enormous increases
in bank credit, the loans of conercial banks to the private sector
continued to expand significantly.

The expansion of credit made by comercial banks to the
private sector seems largely due to the removal of the loan ceiling
policy. The comercial banks as a whole received fewer loans from
the Bank of Korea in 1954 than in the previous year. This indicates
that the increased loans made by the co-ercial banks were due to

increased reserves resulting from the prinry expansion of money

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194
supply in the economy. In this situation, the loan ceiling policy
was supposed to perform its function. The removal of the ceiling
which was imosed upon individual banks, therefore, was responsible
for the increase of bank creditto the private sector.

This credit condition dominated in monetary sphere and con-f
tinued until 1957, when the Financial Stabilization Program was for-
mlated. The Financial Stabilization Program of 1957 was based on a
decision made by the Combined Economic Board that new loans made after
31 Decewer, 1957, should not exceed the sum of resources acquired by
the banking system from the following sources:

1. Private time deposits;

2. Repayment of loans outstanding as of 31 Decewer, 1956;

3. Borrowing from the counterpart fund;

4. Borrowing from the government derived from the Grain

Control Account and Vested Property Proceeds.

This program appeared to be tantamount to saying that no
net credit expansion would result from banking activities during 1957.
This program was considered a successful measure. In comarison with
credit control measures imlemented previously, this program had more
a systematic aspect and achieved some success of credit control. Never-
theless, it should be mentioned that this program itself contained an
elusive aspect and the effect of it was partially offset by the govern-

ment actions.

Table 16 indicated a sharp contraction in the bank credit
expansion attributed to the public sector, while the credit sharply
increased te the private sector. Onite contrary to this superficial
imression, the fact was that the government was primarily respons-

ible fer the sharp increase of credit expansion to the private

sector. In 1957 attemts were made to enforce the collections of

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195
previous loans especially the loans made for agricultural activities.
The attepts were successful and made the government financially
liquid. The government, in turn loaned the collected funds together
with vested property proceeds and counterpart funds, to various
banking institutions in order to facilitate lending operations of
the banking institutions for productive activites. This was the major
cause for a sharp increase in credit expansion attributed to the
private sector in 1957.

The elusive aspect of the program was provision l of the
Program, which allowed banks to make loans on the basis of an increase
in private time deposits. This provision prevailed prior to the
establishment of The Financial Stabilization Program. It may be seen
that,by Table 8,time and saving deposits increased more than 100 per
cent between 1955 and 1956. This tendency continued throughout the
rest of the period of study. A direct cause for the increase of ’
these deposits was a wide scale saving camaign. In particular,
"Bond-saving Deposits” and ”Special Bond-saving Deposits“ were set
up in order to increase the saving deposits. In a slightly different
way, these deposits were set up in order to increase the basis upon
which comercial banks could make loans. The time and saving deposits
increased, so the loans made by the banking system increased. These
saving camaigns were nothing more than attemts to convert illiquid
government bonds, which were held by the public in a comulsory
manner, into liquid forms of bank deposits.

The 1958 situation will be reviewed in support of this issue.

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196

In 1958 the money supply increased very sharply by 33 per cent. The
general nature of credit policy in l958 was about the same with the
Financial Stabilization Program of 1957 with the notable exception
of the over-all ceiling on the aggregate money supply.

The overall ceiling on the aggregate money supply seemed
to have been set on the basis of the growth of time and saving
deposits}.7 The quarterly loan programs and the ceilings on loans ads by
banks were also set on the growth of time and saving deposits. Expan-
sion of net loans ads by all co-orcial banks in 1958 amounted to 17
million hwan despite the fact that bank borrowing from external sources,
including advances from the Bank of Korea, declined by 2 billion hwan.
Needless to say, the njer source of loans in 1958 was time and
saving deposits. This fact is especially noteworthy because 1’58
is the year when the money supply increased greatly on account of
public and foreign sectors.

Credit policies undertaken in the middle of l959 appeared to
be reaction to measures undertaken in the previous period. The pro-
vision to set loans ceiling on the basis of increases in time and
saving deposits was removed in the fiddle of 1959. At the same time
the government and the Bank of Korea enforced a very tight credit
policy. The most powerful tool was the auction sale of foreign ex-

change, which brought about a contraction of money supply in the

37The linistry of Reconstruction reports that there was no
fixed ceiling on the aggregate money supply. Sees
(ministry of Reconstruction, 1959), p. l6. On the other hand, the
Bank of Korea reports that the ceiling was above the actual money

meYo SCC3 W (3.» 0! K”... 1959), We 23.28o

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197
second and third quarters of 1959*when the seasonal demand for money
was increasing.
To demonstrate the ineffectiveness of the loan ceiling policy,
it say be useful to quote a Korean economist's writing.
It was agreed that an increase in bank credit will be limited
in principle to the growth of time and saving deposits. Since
1957, therefore, the role of the ceiling systen as a stabilizer
of economy lost much of its former significance..... On the
other hand, the deposits of banking institutions were increas-
ing rapidly and the fund situtation showed unprecedented isr
prove-ent. The degree of reliance of the banking institutions
on external fund sources dropped continually to the insignifi-
cant level of 4.9% by the end of February, 1959. Under such
circumstances, the continued existence of the ceiling system
lost its justification. The monetary Board, therefore,
decided on larch 5, 1959, to repeal the rediscount ceiling
on the Bank's advances, retroactively as of January, 1959.

The ceilings on commercial bank loans were already repealed
on December 30, 1958.38

It is difficult to understand how the decline of the reliance
of the banking institutions on the Bank of Korea and the incrm se of
bank deposits Justified the removel of ceiling limits on the Bank of
Korea's advances and the loan ceiling imposed on commercial banks.
After a careful study of the loan ceiling policy in Korea, it is hard-
ly possible to conclude that the loan ceiling policy was used
purposefully and effectively. All that can be said about the loan
ceiling policy is that it could have brought about a most direct and
powerful restraining effect on credit expansion.

C. An Appraisal
It has been notedthat the conventional tools of monetary

management are unworkable and ineffective in Korea. Therefore, it is

*—

338 ng Kuk Kim, Ce r Ba a (Seoul: Bank of
Korea, 1959 , ppe 53-540

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198
not necessary to evaluate the changes of these policy variables in terms
of changes in credit expansion. Available tools of credit control
were largely used as a measure of selective control over the aggregate
loan expansion and the quantity of particular loans. Any tool of credit
control, however, is secondary to the loan ceiling policy. Since the
loan ceiling policy is the most imartant and powerful tool, it is
possible for us to draw an inference regarding the credit policy,
in general, by studying the practice and effectiveness of the loan
ceiling policy. Study previously made on the loan ceiling policy
seens to indicate that the policy was not used effectively. Therefore,
the failure of the loan ceiling policy may lead to the conclusion that
the credit policy, in general, failed to restrain credit expansion in
Korea.

It is imortant to note that the credit control achieved was
far removed frow that called for by the optimam pattern of money
supply. Siaply, no policy so far seen to have ained at contract-
ing credit in the private sector.

Perhaps the concept of the optima pattern of money supply
is too harsh in view of the never-ending demand for bank funds in
Korea, especially in the eyes of those who have close association
with business activities. It is certain, however, that the
cruelty ef inflation in Korea has been very real. It seens that
credit policyvin Korea has always been pursued by a price level
without acknowledgnent of the fact that the credit policy followed
the price level. when the price level rose sharply, the rate of
credit expansion decreased slightly. As soon as the price spiral

seened to slow down, however, credit was expanded until another turn

I.

"H

d)

199
of the price spiral occurred. Everything points to the conclusion
that the Korean government and banking system failed to achieve the
goals of nonetary policy. 'It my also be argued that the extremely

diversified and comlex credit tools available were misused.

CHAPTER VIII

SUMRY AK) COTCLUSION

W
The recent economic development of Korea is largely the by-

product of political development. 0n the eve of awaking from a
long dream of self-contained Confucianism, the 'Hermit Kingdom"
was occupied by the Japanese isperialists for almost forty years
and capitalism as an economic system ste-ed largely from the
attendant Japanese influence.

The defeat of Japan in 1945 fulfilled Korea's wish to
be independent. Political independence is, perhaps, easier to
achieve than economic soveriegnty. The Korean economy was left
crippled and unbalanced as the ties with Japan were abruptly
severed. To comound her already severe difficulties, the
tardnation of the Japanese occupation in Korea was also followed
by the bisection of the country which further violated the tenets
of economics whatever political expediencies may have been served.

North Korea was primarily an industrial zone, while South
Korea was predominantly an agricultural area with a modest amount
of light industry. The break down of comlementarity between the
llorth and South forced the South Korean facilities of production
to the verge of extinction. South Korea needed a structural re-

erientation urgently and i-ediately.

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201

From August 15, 1948, when the Republic of Korea was estab-
lished until by, 1%0, the South Korean economy showed significant
progress uinly because of effective use of E.C.A. aid. Efforts for
economic stabilization and reconstruction on the part of the E.C.A.
and the Republic of Korea, however, were interrupted by the Korean
Ilar. The war damage was great. lore than half of the existing
facilities of production and housing were destroyed by war. This
was indeed a vital blow to the South Korean economy.

A positive step for economic reconstruction was undertaken
in 1953 with an agreement about financial stability and economic re-
construction between tho Republic of Korea and the United States.
By‘ 1954, industrial activities had reached the pro-Korean-Iar level.
By l960, the national income was about 25 per cent above that of 1954.
This was largely due to the great contribution of United States
economic aid. Nevertheless, the basic lines of policy contemlated
by the United States and Korea conflicted. The United States put
emhasis on stability before reconstruction. The argument was to
get stability first and then grath would take care of itself. On
the other hand, the Korean government omhasized reconstruction
before stability; growth was to be sought at all costs. This
conflict resulted in a lack of coordination of economic policy
between the United States and the Korean government until about
1955.

Economic reconstruction was relatively slow. The general

consensus has been that this was partly due to inadequate and

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202

irregular arrivals of econonic aid to Korea. An aggressive
reconstruction effort, backed by bold invest-ent of econoaic aid
in Korea, night very well have produced nore rapid econoaic recon-
struction.

Failure and success in nintaining nonetary stability and
in facilitating econonic growth and the efficacy of nonetary nan-
agenent of a country largely depends upon the institutional arrange-
nents.

nus technical and structural franework of the present day
Korean banking systen was nodeled after the Japanese systen. By
and large, the banking systen' was established as a result of the
penetration of Japanese bankers into Kerea and the goveruent policy
of establishing banking institutions as deened necessary. As a con-
sequence, the banking systen in Korea developed into a fairly
diversified and specialized pattern and its network covered a wide
area of the country.

The banking systen had a definite inclination to expand.
This inclination seens to reflect largely the historical role of
Japan. lhen Japan took over Korea, the noney sector of the econony
expanded rapidly due to the establish-ent of private property
ownership and the develop-ent of transportation and comnication
facilities and a mshrooning growth of the banking systen see-ed
necessary. As Japan established political and econoaic control in
Korea, the target of expansion shifted to lanchuria and China. For

this reason, the Korean banking systen once again expanded without

 

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203

interference.’ An obvious examle, the Bank of Chosen was, indeed,
the largest co—ercial bank and develop-ent bank; the history of
the Bank was never narked by a contractionary policy of credit
control.

After the liberation of Korea, existing financial institutions
were chaotic. Specialized features of the banking systen gradually
disappeared until every bank, except the Bank of Chosen, was prinrily
engaged in co-ercial banking operations. On top of this disarray of
the banking institutions, the Bank of Kerea fed loans into various
banking institutions.

Banking reforn was inerative and urgent in such a situation.
The Banking Reforn of 1950 ained at restoring the specialized features
of banking institutions and strengthening the South Korean banking
systen as a whole. ‘ The Banking Reforn certainly contributed to
restoring and strengthening the South Korean banking systen. The
establishnent of the Monetary Board was expected to nake the Bank of
Korea a genuine central bank. The Act of the Bank of Korea emewered
the bnetary Board with wide and flexible discretionary powers.
Superficially, it did appear to be an imortant and desirable innova-
tion. however, the predoninant banking structure renained the sane
as before.

Co-ercial banking practices have been highly inflationary
throughout the period of this study. The capital-assets ratio was
neager, yet the banks Id. loans in considerable excess of the

donestic sources of funds. hny of the loans were nade through the

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204
”pull“ and "push" of political pressures. Consequently, loans‘were
nade without any forn of collateral and developed into delinquent
loans.

The absence of short-tern noney narkets linits the scope of
conventional tools of nonetary policy. The conventional nonotary
tools, grown out of the London and low York noney nrkots, require
well-developed nonoy nnrkets nhich, in turn, include sensitively
structured sub-narkets. The central bank usually confines its opera-
tion to the short-tern noney nrkots, nerely watching and adjusting
the cash balance and liquidity conditions of the connercial banks.

In Korea, the reserves and reserve ratio of connercial banks
underwent substantial fluctuations. The reason for this is that
there are no short-tern nonoy nerkets, so that banks do not possess
a variety of liquid assets and a high proportion of the total
nonoy supply is conposod of currency. The highly fluctuating soa-
sonal flow of currency into and out of the banking systen produces
a highly volatile and unpredictable reserve status to sons extent.
Because of the absence of short-tern noney narkets, open-narket
operations have never been used in Korea. The discount rate policy
has been used quite frequently in Korea. Its use has, however, been
as an instrunent of selective control, rather than of the credit
acco-odation and credit control. Du to the big gap between interest
rates in the fornal and the infernal nonoy narkets, any snail
change in«discount or bank rates did not curb the donand for bank
funds. The increase of bank rates to nearly the infernal narket

rates night have been an effective neasure for credit contraction.

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205

The consequence of this policy was considered undesirable because
it meant putting the funds for productive invest-ent in cometition
with the speculative denand for funds. The discount rate was used
in rationing the short supply of bank funds to preferred borrowers.
If it had been managed well, the effect could have been beneficial.
However, political pressures seemed to cause an adverse effect.

A substantial effect of reserve require-ent manipulation
was seen especially in 1952 and the earlier part of 1953. The
potential effect of reserve requirements manipulation was largely
nullified by the relatively easy access to the Bank of Korea for
loans and advances.

The scope of monetary management is extremely limited due to
the dominance of the government in credit expansion. Throughout the
period of this study, the government failed to meet its own expendi-
tures out of nen-inflationary sources of revenues. The consequences
were heavy overdrafts on the Bank of Korea. The government also
failed to finance the budgetary deficits by sales of bonds to the
public. In view of the absence of money narkets and the low propensity
to save, alnest all bond issues were absorbed by the banking systen.
The persistent overdrafts of the government on theBank of Korea,
indeed, have been the njor factor causing the expansion of aoney
supply. Goverrnent agencies also shared the sane apple until 1955.
Later, the govermnt undertook the financing of industrial produc-
tion through the establishment of the Korean Reconstruction Bank and
lending funds to all banking institutions. A major factor in the

contraction of money supply has been the proceeds from the sales of

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206

aid goods, which were deposited at the Bank of Korea. The size of
the counterpart funds deposits directly affected the governnnt's
budgetary position and the total money supply.

When credit expansion attributed to the public sector exceeded
the optima rate of increase in aoney supply, the Bank of Korea should
have tried to reduce the bank credits available to the private sector.
There was no sign of such a serious attempt. Bank credits to the
private sector, on the contrary, have increased persistently throughout
the period, although a decline in the rate of bank credit expansion
was sporadically attemted. The Bank of Korea's advances and loans
to co-ercial banks were persistent throughout the period. This caused
the tools of credit control to lose their meaning.

The seasonal behavior of money supply reflects the character-
istics of the agricultural econo-y. After the harvest season, the
money supply increases sharply. One reason for this is the general
custom of stocking one year's supply of rice, fuel and essential food-
stuffs. Another reason is the enormous increase of bank credits to
agricultural activities during the harvest season. During the
harvest season, a great proportion of the total money supply is
issued in the fora: of currency. This indicates that the aoney
increasdduring the harvest season is spent inediately.

The love-ent of aoney supply during the period of this study
is marked by three distinct periods: the post-liberation period,
the Korean lar period and the period of currency reform and tight

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207

The post-liberation period was marked by a sharp increase
in the money supply, due to excessive printing of the Bank of Chosen
notes by the Japanese government in order to clear unpaid debts and
to pay Japanese citizens for repatriation. The Bank of Chosen notes
circulated in North Korea, Manchuria and China and also flowed into
South Korea due to the migration of citizens and refugees from the
North Korean communists. The rate of increase in the money supply
decreased after 1946. However, the rate of increase'was' very high
at an annual rate of 70 per cent.

The Korean lar caused another sharp increase in money supply
in 1950, 1951 and 1952. During the war period, practically all govern-
ment expenditures for war were financed by printing notes. As General
hcArthur gained hope of victory, novements for economic reconstruction
began to appear Aan}. the prospects for economic reconstruction became
brighter as the truce negotiations came closer to an agreement. A
series of attemts to overhaul the economic structure was nade by
the Korean government.

The currency reform was the most significant change made.

The purpose of the reform was to absorb excess liquidity. As the
result of the reforn, the-government succeeded in imounding the
money supply to a greater degree than anticipated. The series of
exchange rates for the blocked accounts, however, was reduced by
Congress. Consequently, the money supply tended to increase from
imrch onward, after a little teaporary slack in February. The in-

crease in money supply after the reform, however, was caused by the

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208
increased spending of the government much more than it‘was caused by
relaxation of exchange rates. It seems that the government attempted
to convert resources from the private sector to the government sector
in|a wholesale fashion on the occasion of the reform.

The rate of increase in money supply after 1955 tended to
decrease, largely due to the increase in American aid and the improve-
ment in the government budgetary policy.

The movement of the money supply during this period of the
study indicates that the rate of increase‘was closely associated with
political developments. The institutional arrangements and the
mentalities that dominate the monetary machinery certainly contrib-
uted to the excessive increase in money supply. It seems that the
money supply was chasing the level of general prices‘without knowing
the fact that the price level‘was chasing the money supply. Honey
supplwaas usually increased until a sharp spiral of general prices
occurred.

The interpretation of the movement of the price level since
1945, based on the index of the average denomination of currency,
brings out some interesting contrasts to that of the Seoul whole-
sale price index. Economists in Korea made faulty Judgments about
the price movements, velocity'and economic activities in the period
of post-liberation, if the index developed herein more accurately
reflects events in Korean economy than does the official data. They
interpreted the process of eliminating the discrepancy between the

free market and the controlled market price as an inflationary

 

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209
spiral, which necessarily led to the conclusion that velocity increased

soamthing like 3 times. But, in fact, the evidence is clear that
velocity declined during this period.

An especially interesting observation is the sharp increase
in prices during 1955. The rise in prices was associated with the
expected depreciation of the foreign exchange rate and the political
instability created by the expectation. The argument for revising
the exchange rate was once again brought out because of a high price
increase after the currency reform, especially in the latter quarters
of 1954, as viewed by the Seoul Wholesale Price Index. According to
the index of the average denomination, the price level during 1954
was relatively stable. If this is correct the wholesale price index
was in error.

The*wholesale price index seems to understate the true move-
ment of the price level during the pemd after 1954. This might
have been due to the attelpt of the government to manipulate the
price index in order to show the success of controlling inflation,
in particular to prevent the further revision of foreign exchange
rates.

From the latter quarter of 1959 to 1960, an election year,
prices started to rise according to the index of the average denom-
ination, while the wholesale price index conceals this fact. During
the election year, money increased and circulated faster than before,
until the rigged election brought on the student revolution in 1961.

In the matter of policies for stopping inflation, there has

 

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210
been a heated controversy over’whether to seek monetary stability
before reconstruction or reconstruction before monetary stability.
This controversy has been the basic conflict of policy between the
Korean government and the United States.

It is important to stress that the problem of inflation in
Korea e-nated from the damand side, that is, the urge to reconstruct
and develop. when the government dominates in economic activities as
in Korea, the’demand for money is usually associated with the ability
to run the press, rather than the availability of non-inflationary
sources of funds.

The argument for “stability first” has mach more merit than
that for “reconstruction first." The proponents of the stability
argument, however, often treat money as a passive factor in the
context of economicldevelopment. lonetary policy is purely a matter
of eliminating fluctuations of the price level. However, money does
lake an important contribution to economic development. In this
sense, the goals of monetary policy are defined positively in this
study. As the fundamental objectives of monetary policy, the Bank
of Korea should concern itsolf with the supply of money in such a‘way
as to maintain monetary stability and also a slight degree of infla-
tion to induce the growth of economic activities. This propostion
is especially meaningful in the case of Korea because the issue in
Korea has been the problem of economic reconstruction, rather than
that of economic development.

The optimm pattern of money supply is estimated on the basis

of the context of the quantity theory of money. This method of

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211

estimation is possible because the behavior of velocity in Korea has
been relatively constant over the period of 1952 to 1960.
W

The purpose of this study was to investigate the problem of
inflation with particular emhasis on the role of the Bank of Korea
from 1945 to 1960. .- The criteria for judging the performance of the
Bank of Korea were provided by the estismtion of the optimm pattern
of money supply. The actual rate and amount of money supply increase
have been far greater than the optimm rate. Thus, it may be con-
cluded that the Bank of Korea failed in its Job of maintaining
monetary stability and of facilitating economic growth.

It might be argued that the Bank can do only a limited
number of assigned Jobs because of the government dounance and
political pressures, as one often hears from men at the Bank. This
argument certainly contains elements of truth, especially as applied
to the period when the country was involved in a national crisis.
However, it was shown that the increase in money supply has been
persistently greater than the optimm amount even during the period
of alleged tight monetary policy. For exsmle, it was observed
that the Bank of Korea enforced high reserve requirements on one
hand and provided advances and loans to the co-ercial banks on
the other hand. The evidence suggests that the Bank of Korea
cannot shift its own responsibility to another agency.

Bank credit attributed to the public sector alone exceeded

the ootimm amount of money supply. In this situation, an obvious

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212

attemt on the part of the Bank should have been not only to sterlize
the secondary money expansion effect by requiring 100 per cent reserve
requirements on the subsequent increase in deposits at the conercial
banks, but also to contract the equivalent amount of credit in the
private sector. There was no such serious attemt. Only sporadic
attemts to restrict the credit expansion to the private sector were
made. But even such sporadic attempts failed to achieve the policy
goals.

In regard to the failure of the Bank, the government certainly
mst share the responsibility because the credit expansion to the
public sector alone has been far greater than the optimm criteria.
The Bank certainly has not been in a position to restrict credit
expansion to the public sector. If the government, in its zeal to
accelerate economic reconstruction, pursues irresponsible financial
policies necessitating undue interference upon the central bank, there
is nothing that the central bank can do about it. no central bank
can win a battle against the government. This, however, does not
imply that the central bank should be subject to government inter-
ference.

In this period, the coordination rather than the subordination
of the lonetary Board seemed desirable. There was indeed a need for
imrovement in the relationship between the government and the Ionetary
Board. For examle, it seemed that the provision in the Act of the
Bank of Korea which provided for the linister of Finance. Without the
medaership of the Iinister of Finance in the Monetary Board, the

 

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213

government would have been more careful in planning the budget. Had
this measure been taken, some progress would have been made toward
economic stability in Korea.

Asito the medaership of the Board, there is no provision re-
quiring that at least one economist from an academic circle be admitted.

There seems to be a need for this provision in Korea. A scholar is

apt to be more objective than a politician or a businessnn.

Institutional development and arrangement seemed to have been

 

imortant in Korea. The banking reform of 1950 unfortunately did not , ‘
recognize this point. The banking reform, in essence, appears to i
have equipped the Monetary Board with as many discretionary tools and
powers as possible. This necessarily resulted in the diversified uses
of credit tools and, in turn, in cowlication and confusion in monetary
management. ,The conflicting usage of a variety of tools appeared to
have nullified the potential effects of policies. For examle, the
Bank of Korea inlemented an allegedly tight loan ceiling policy to
co-esdsl banks. The banks, however, had relatively easy access to
the Bank for loans and discounts. Eligibility rules of the discount
policy have been in direct conflict with the loan ceiling policy.
When reserve requirements were used in retaining credit, advances and
discounts of the Bank were also made to conercial banks.

The selective nature of Credit control in these comlex
assortments seemed to have been clearly adverse to the goals of monetary
management. One may argue that the selective nature of credit control

was essential in fostering particular industries deemed essential in

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214

the national economy. If this were true, why was the loan ceiling set
so high that credit expansion to the private sector contributed to
additional inflationary pressure? The ceiling was determined on the
basis of the expected growth of demand and time deposits. lhen demand
deposits were excluded from this provision, the growth of time deposits
was used as the basis for the loan expansion. For this purpose, the
illiquid government bonds were allowed to be used as time deposits, so
that illiquid bonds could be converted into forms of liquid bank deposits.
Perhaps poor management of credit policy could have been responsible for
this consequence. At any rate, there seemed to be no ground on which to
argue that only more desirable loans were allocated by the selective
types of credit tools, in view of the fact that loans made even by the
Reconstruction Bank were used for political camaigns and that funds
flowed into the informal markets for higher interests: and high profits.

The argument presented above leads ‘to this conclusion. The
purpose of monetary policy is to control the money supply in a judicious
fashion, if not in the optimam. The purpose of monetary policy is not
to create a variety of policies. Because of the use of a variety of
credit tools in a comlex fashion, the Bank of Korea seemed to have
switched to a particular policy even before the Bank estimated the
effect of that particular policy.

A simler set of tools would have been more effective. For
this reason, the measures provided by the banking reform may have to
be modified in the future. In particular, resort to selective types

of monetary control does not seem to be desirable, especially when

215
political pressures are dominant. A highly recomaended tool of credit
policy is the reserve requirmment policy. This tool is simple to use.
Primarily, it is free from undue pressure of particular groups or in-
dividuals, which would invariably result in‘well-designed policies of
selective control. The major factors‘which affect the reserves of

commercial banks in Korea are not only beyond the control of the

 

central bank, but are also highly irregular in their changes. The;

irregularity of these factors is responsible for the high fluctuation

 

of the total money supply. The higher the reserve ratios are, the

‘smnr"'

less the fluctuation of money supply. The irregularity and perverse
elasticity of the money supply should be prevented at all costs. When
the government dominates economic activities as in Korea, higher
reserve requirements will facilitate the diversion of resources from
the private sector to the public sector. As a result, higher reserve
requirements, possibly as much as 100 per cent, would facilitate the
prediction and implementation of an optimum pattern of money supply.
Open market operations have never been used in Korea. Their
use wouldseem to be highly favorable. Clearly,.their use for con-
tracting money supply would face many difficulties. However, the
use of opensarket operations to increase money supply is possible
without any difficulty. At the end of 1960, national bonds and
industrial debentures held by banking institutions and the public
amounted to roughly 10 years of resources, which was sufficient to
increase the money supply 10 per cent annually. Same portion of
the increase in money supply can be made by the purchase of bonds.

The advantage of this scheme is that it provides the opportunity to

 

216
foster money markets, which in turn will make open market operations
possible in both directions. Unitl operations can be conducted in
both directions, contraction of the money supply can be achieved
either by reserve requirements or the sale of foreign exchange.
This study also brings out the iaportance of the use of the

index of average denomination of currency as a useful index of price

v ~ ..T Ql
\
. . . . .

level. The use of this index would certainly be meaningful in many

underdeveloped countries where there are no reliable indices of the

 

price level. i =

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218

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Johansen, Leif. "The Role of the Banking System in a Marcro~Economic
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Kim, Sam 800, "History of Kci," Jae Jeung. Seoul: Jae Jeung Sa.
Date Unavailable.

9‘ ‘0 ' .-
_w.p‘g.- "-

 

 

 

On
0 P
.
o P O a
1
I
x t c 0 v i l
. C 'u
I . o
A
0 I I
O
I O c
I
C
v a .
n o .
Q
0 o
I
I
n
o a a
Q
o
.
. . pk
.
a
I O
n 0
I
o
c
. OK
1
O . O
I
.
O I
.
o
O P
. I
. .
_
ill-Ill}!

ill
t: f X... . n-

Koh, Sung Je. "Deve10pment of the Mbdern Banking System in Korea,"
Kgrean Quarterly. II, No. 4. Seoul: Spring, 1960.

Keum Yoong Sa. "History of Financial Institutions," Keum Yoong,
Seoul: Keum Yoong Sa. JUne, 1954.

 

Klein, JOhn J. "German Money and Price, 1932 - 44," Studies of the
gpantity Theorypof Mgpey. ed. ifilton Friedman. Chicago:
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Kaldor, Nicholas. "Economic Growth and the Problem of Inflation," JV
Econgmica, August, 1959, and November, 1959.

Leo, Hae Dong, "Distress of Public Finance," Jae Jeung, Seoul: p
Jae Jeung Sa. June, 1956. i

 

 

Lewis Arthur. "Economic Deve10pment with Unlimited Supplies of
’
Labor," Economics of Underemnloyment. Bombay: Oxford
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Navarrete, Alfred, Jr., and Navarrete, Ifingenia NL "Underemployment
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Park, Kwan Sook. "Some Criticisms on Japanese Claims for PrOperty
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Patinkin, Don. "Keynesian Economics and the Quantity T'ehory,’I Post-
Keynesian Economics. ed. Kenneth K. Kurihara. New Brunswick:
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Pazos, Felipe. "Economic Deve10pment and Financial Stability," Staff
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Pesek, Boris. "Mbnetary Reform," JOurnal of Political Economy,
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. "Mbnetary Analysis of Income Formation and Payment
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o . o o . O
A V .
a o
_ p . . A
. . g n
. u
. . o
. . , n
. . . o . p
I - o ‘
' f
I P
. .
a u p g o .
.
D
. o o o
o e
‘ I O . b I
i .
. ‘
|
' O ' -
. o l a . g
. U
- o O O
.
.
I a .
a 9 . .

 

   

224

Rosa, R. V. "Interest Rates and Central Banks," Money, Trade, and
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‘3' fl...- -

225

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University of Oregon, 1961.

 

APPEND IX

 

CHAPTER A

THE INDEX OF AVERAGE DENOMINATION OF CURRENCY

The Bank of Korea issues notes of various values. Let us

call this the distribution of note-issue. The distribution of

 

t:
note-holding occurs when the public holds notes of various values. E
In the table presented below, the distribution of note-issues and g
noteéholdings are assumed to be equal. This is because no data a
for the distribution of note—holding are available in Korea. i

This assumption is a reasonable one because no central bank can
issue notes which are not held by the public. The distribution of
note-issue is adjusted for the destruction of some obsolete notes
in Korea. Therefore, the distribution of denominations in various
values held by the public in Table A is derived by the distribution
of note-issues after the bank vault cashes are subtracted from the
amount of notes issued.

From September, 1945, to January, 1953, the average denomina-
tion is expressed in terms of yep, old currency. From February, 1953,
to December, 1960, the average denomination is expressed in terms of
hyeg, new currency. The average denomination in terms of won and hwan
are connected into one index by the method discussed in Chapter VI of
the text.

One and five-won notes and one and five-hwan notes are all
assumed to be held by the public because the total value of these
notes are insignificant relative to the total note-holdings and be-

cause they are relatively constant in size throughout the period.

I

 

 

 

 

 

II

TABLE A

DENCMINATIQJS HELD BY TIE PUBLIC AND

THE INIEX 0P AVERPGE ENOJINAIIQJ

 

Total
1,000 500 100 10 5 1 values
won won ‘won won won won won
1945,9 5,751 2,361 128 101 8,331
12 5,966 2,256 123 100 8,438
1946, 3 6,293 2,212 110 95 8,698
6 6,358 2,495 106 91 9,043
9 8,172 2,390 97 89 10,736
12 13,740 2,637 101 88 16,542
1947, 3 13,832 2,150 93 88 16,152
6 14,982 1,926 89 86 17,074
9 17,326 1,799 87 86 19,286
12 29,029 2,002- 88 87 31,183
1948, 3 25,453 1,503 87 88 27,109
6 26,978 1,208 84 88 28,342
9 27,664 1,094 84 88 28,910
12 39,407 1,080 85 88 40,632
1949, 3 33,817 982 85 88 34,914
6 37,319 1,080 86 88 38,573
9 43,854 1,131 90 88 45,143
12 69,271 1,222 92 88 70,674
1950, 3 57,831 1,240 93 89 59,253
6 60,902 1,245 95 89 62,331
9 32,693 53,057 1,264 94 89 87,220
12 180,049 43,340 1,319 ,96 89 224,935
1951, 3 284,812 39,088 1,266 100 89 325,500
6 372,048 28,408 1,253 100 89 401,800
9 428,020 17,680 1,264 100 89 447,300
12 523,958 13,842 1,262 100 100 539,300
1952, 3 567,760 7,901 1,254 100 100 577,000
6 623,061 7,651 1,262 100 100 632,100
9 730,632 8,482 1,262 100 100 740,500
12 962,881 .8,579 1,259 100 100 974,300
1953, 1 990,800 8,391 1,242 100

100

 

1227a 1258, and 1260: I]! Monthly Stgtistigal Rovigw

Source: The Bank of Korea,

and Ec 81:11:05 1 1 o

The Econggg Annggl, 1255, 1&5

March, 1951

 

 

 

r.
0
' v
I-
\
1
0'
v

4...:«v-o- A

4 a

. - — II.-
- .

.4 v ~o -

-.‘C.
6‘1"

 

-7. ‘1-

III

TABLE A Continued

 

No. of Notes Average Denomination in Won Index 1947:100
421 19.8 45.02
410 20.6 49.04
401 21.7 51.59
426 21.2 50.58
429 25.0 59.55
509 32.5 77.33
459 35.2 83.72
447 38.2 91.02
457 42.2 100.5
595 52.4 124.76
510 53.2 126.55
495 57.2 136.24
491 58.9 140.24
607 66.9 159.32
542 64.5 153.46
587 65.8 156.55
658 68.6 163.34
'922 76.7 182.50
810 73.18 174.23
841 74.07 176.36
797 109.37 260.41
854 263.51 627.40
922 352.92 840.28
901 445.73 1,061.25
851 525.48 1,251.15
909 593.51 1,413.13
892 646.74 1,539.85
946 668.30 1,591.19

1,062 697.50 1,660.71
1,295 752.55 1,791.78

1,322 757.95 1,804.65

 

IV

TABLE A Continued

AFTER CURRENCY REFORM OF FEBRUARY, 1953

 

Total

1,000 500 100 10 5 1 Values

Hwan Hwan Hwan Hwan Hwan Hwan Hwan
1953, 2 951 1,812 5,344 570 92 22 6,890
3 1,482 7,536 837 104 24 9,976
6 1,371 8,084 2,774 49 21 12,284
9 3,797 8,223 5,063 225 23 17,306
12 6,613 9,377 6,241 94 24 22,334
1954, 3 6,399 12,340 5,407 64 25 24,207
6 6,858 16,236 7,257 53 27 30,406
9 6,706 19,697 7,066 60 28 33,517
12 6,801 26,362 6,766 55 29 39,979
1955, 3 6,524 25,951 3,245 49 28 5,767
6 6,747 31,750 2,040 48 28 40,595
9 6,711 41,009 1,010 50 29 49,210
12 6,625 51,064 1,019 51 29 58,777
1956, 3 6,457 323 42,085 961 51 29 49,796
6 6,486 1,754 45,126 1,003 53 30 54,361
9 6,570 4,115 49,106 1,152 55 30 60,909
12 6,521 11,205 54,413 1,216 57 30 73,338
1957, 3 6,383 19,376 36,859 1,095 58 31 63,621
6 7,698 23,152 29,122 1,120 58 3 61,191
9 7,568 23,596 33,289 1,170 60 32 65,716
12 7,870 25,478 51,277 1,300 60 33 86,048
1958, 3 7,490 24,784 40,692 1,233 60 33 74,292
6 7,597 25,270 38,714 1,256 61 33 72,931
9 8,674 30,340 47,870 1,343 61 34 88,368
12 15,559 37,108 56,773 1,362 62 34 111,057
1959, 3 16,315 39,474 41,204 1,296 63 34 98,669
6 17,334 40,992 33,988 1,332 64 35 93,973
9 19,588 43,301 37,380 1,339 65 35 101,954
12 31,251 44,469 46,116 1,311 67 36 123,595
1960, 3 42,969 38,444 27,816 1,213 70 36 111,659
6 58,781 36,309 20,312 1,126 69 36 117,873
9 70,073 36,667 16,126 1,042 69 37 123,590
12 86,660 33,644 16,028 973 69 37 139,319

 

“‘21:“- -‘ mus-unanmr 7

 

 

 

 

No. of Notes

TABLE A Continued

Averaqe Denomination in Hwan

Index 1947:100

 

152
205
390
660
767
708
932
950'
987
628
565
556
658
563
602
662
736
566
500
549
747
632
616
728
840
683
620
661
763
597
551
535
557

45.4
48.6
31.5
26.2
29.1
34.2
32.6
35.3
40.5
56.9

71.7 ’

88.4

89.3

88.4

90.3

92.0

99.6
112.4
122.4
119.8
115.3
117.5
118.4
121.3
132.2
144.4
151.5
154.1
161.9
187.2
213.7
231.1
250.2

10,811
11,566
7,491
6,240
6,930
8,137
7,764
8,340
9,644
13,554
17,081
21,044
21,256
21,050
21,493
21,901
23,721
26,771
29,147
28,517
27,442

- 27,976

28,186
28,880
31,473
34,370
36,078
36,679
38,539
44,564
50,892
55,035
59,560

 

CHAPTER B
COMPARISON OF INDICES

A. Regression Analysis

Regression analysis is used to compare the movement of the
indices of Seoul wholesale prices and the average denomination of the
currency with four indices of the money supply and real output.
Regressions are calculated with each price index as a dependent
variable and various combinations of four selected indices as
independent variables. The four indices selected are:

1. Index of the money supply

2. Index of real output1

3. Index of rice output
4. Index of foreign aid

 

1The writer computed the index of real output from 1946 to
1954 by a very crude method. Twelve major commodities are weighed
by the 1955 base used by the Bank of Korea.

 

 

Commodities Sub—weights Weights

1. Rice 50%
20 Mining 505%

a. Goal 53.57%

b. Tungsten 15.48%

c. Gold 30.95%
3. Manufacturing 42.1%

a. Rubber Products 8.4%

b. Paper Products 3.2%

c. Ceramic Products 4.8%

d. Cement 0.

e. Textile Products 21.4%

f. Clothes 54.8%

g. Salt 6.7%
4. Electricity 2.5%

This index is connected to the index of industrial production published
by the Bank of Korea from 1954 on. This index is only an indication of
industrial production rather than the output of the total economy. See
Chapter C, Appendix.

VI

 

| , .—

 

 

VII

The regressions of these variables are calculated by both
natural and logarithmic methods. Index No. 1 is used as the only
independent variable in four equations and is used with each of the
other selected indices in a total of twelve regression equations.

The price level must be consistent with the given money supply
and real output. When the money SUpply increases, velocity being

constant, prices will go up, while prices will decrease as real output

Wurst-i1“.- umflmfl: firm-1Q,

increases. In the regression analysis with natural numbers, observa-
tion is focused on the relationship between the price levels of indices
and the levels of reapective indices. When data are converted into
logarithms, the relationship between the price index and the other
indices is investigated in terms of percentage changes, rather than
levels. Since the changes in prices rather than the levels of prices
are important in this study, the regression analysis with logarithms
may provide a better result than that with natural numbers.

Since the prices change directly with aggregate spending
and inversely with the availability of goods and services, the signs
of regressions are expected to be positive for the index of money supply
and negative for the indices of real output.

It also should be mentioned that interdependence among "inde-
pendent" variables seems to be great in the case of Korea. For example,
much of the production of farm products and manufactured goods is
financed by bank funds.

Results
Both the index of average denomination of currency and the

Seoul Wholesale Price Index are highly correlated with the index of

 

 

 

VIII

money supply in natural numbers and logarithms, as is observed in
ecuations 1, 5, 9, and 13. The correlation coefficients range from
.9952 to .9654. For both indices, the correlation coefficients do
not generally increase significantly as different indices of output

are combined with the index of money supply. This seems to indicate

 

that the money supply is the most important variable which affects 3
prices. The close agreement of the correlation coefficients obtained

between the index of money supply and the two indices of the price

level indicates that there is little basis in this comparison for the i

selection of one price index over the other.

In both natural numbers and logarithms, the signs of the
regression coefficients of money supply are positive in all cases
for both indices. Furthermore, the regression coefficients are signi-
ficantly different from zero at the 1 per cent level by the T test.
These evidences, therefore, indicate that there is a strong relation-
ship between money supply and prices.

With the data converted into logarithms, the signs of the
regression coefficients of the index of foreign aid and real output '
are negative, as expected, while the sign of the index of real output
is unexpectedly positive in the case of the index of average denomina-
tion. However, none of the regression coefficients are significantly
different from zero at the 10 per cent level. In the case of the
index of the Seoul wholesale prices, the regression coefficients of
all indices of real output have negative signs. The regression
coefficients for real output and rice output are significantly different

from zero at the 1 per cent and the 10 per cent levels respectively.

 

 

 

IX
TABLE B
RESULTS OF REGRESSION ANALYSIS
Yl (Index of Average Denomination) ' f(xl / 13 /‘X3 8 X4 )2
with natural numbers

 

 

 

 

 

 

 

 

 

Y intercept X1 XZ XB X4 R
{*5
1
-521.7 .7874 .9654
(1215.41_ 1. 0290
2 if!
1086.146 .8312 -28.3536 .9655
(8704.934 31.24041_ 1150,2563)
3 if.
1209.054 .7946 -20.3745 .9655
(10823.1é6L 110757 (1253mm
4 if!
2042.858 .8494 -9.5657 .9679
411923304) (.0849 Amiga?)
12 (Wholesale Prices)
Y intercept X1 X2 X3 X: R
5 {if
1711.434 .4285 .9749
(789.874 1.02721
6 his
-1266.892 .3473 52.522 .9761
(3912,1748) (.1082L (67.6241
7 it!
9303.961 .4600 ~89.3802 .9799
(4467.982) 1,3123) 151.8789)
8 at“ *
~6l7.374 .3722 8.686 .9818
11299.62?) (.0358) 14.083)

 

' T test of b coefficient significant at 10% level
* T test of b coefficient significant at 5% level
** T test of b coefficient significant at 2% level
*** T test of b coefficient significant at 1% level

X 3 Index of money supply X3 : Index of rice output
X2 I Index of real output X4 2 Index of foreign aid

- y . 7 I 1 . , ,
: o o >—
' f - \ ' ' 1 _
o F- . o
‘ o \ O _ ‘ ‘ l
u — o a 4
‘ O < n \ a - f
_ ‘. . ’ - 4 \. . . .2 . . .1
1 u - o 3 a
. O l ’6 \ _ O _ A
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\
_ n g 0 1 l
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. o o , 0 ~——
2 ' \ ' . . \\ ’ fl ... z _
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q « O . l. 0 | - ....
q ) \ . . ‘ I \ o . t ‘

. . . . a
I .
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a4
5
' -c
H. ' ‘

 

X
TABLE B
(continued)
RESULTS OF REGRESSION ANALYSIS
Y1 (Index of Average Denomination) 2 f(x1 / X2 / X3 / $4):

with logarithms

 

 

 

 

 

 

 

 

 

 

Y intercept X1 X2 X3 X: R
9 iii
-.O742 .9834 .9952
1.1012. 1.0267)
10 iii
'0 5242 o 9301 o 3380 o 9955
1.47071 (.0607) 1.3452)
11 I}!
1.4343 c 9978 -0 7782 o 9975
1.7625) 1.02651 , (.3253)
12 ii!
"’0 0200 09886 '0 0289 09952
(.3377) (.0419) .111213)
12 (Wholesale Prices)
Y intercept X1 X2 X3 X4 R
13 iii
.3289 .8730 .9934
(.1057) 1.0280)
14 if! ii}
1.8624 1.0545 -1.1518 .9987
(.2302 (.0297) 1.1688)
15 use '
11.015912 1.01971 (.5327)
16 {if

(.3327) 1.0418) 1.1710)

 

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7 ‘_ /
t o 0 7h
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7

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c - a M c 9-

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c a 7— a n

\ ’ X I \ '
u n 4 I _
4 - x . n . / \ ' _ . .'

x

o I a , o
0 ‘ Q '
. \ t I

o , O _ u o

\ e \ 4 / . a

y
C O O < I
t " \ . ’ c _ '_ /

a I o c

3 I x. n , 1 \ . ,

 

   

 

 

XI

With natural numbers, the regression coefficients of real output,
rice output and foreign aid show negative signs in the case of the
index of average denomination of currency. However, the regression co-
efficients are not significantly different from zero at the 10 per cent
level in any case. In the case of the index of wholesale prices, the
regression coefficients of real output and foreign aid have positive signs.
The regression coefficient: for foreign aid is significantly different from
zero at the 5 per cent level. If this were true, this fact indicates a
peculiar phenomena and casts some doubt on the validity of the wholesale
price index.

As far as the signs of regression coefficients are concerned,
the index of average denomination seems to be a better index than the
Seoul Wholesale Price Index with data in natural numbers. The Seoul
Wholesale Price Index, however, seems to be a better index than the index
of average denomination with data in logarithms. In regard to the Sign
situation, there is again little basis for the selection of one price index
over the others.

The behavior of each variable seems worthy of attention. For
the analysis of the behavior of each variable, we will confine our
attention to the regression analysis with logarithms.

It is observed that the behavior of indices of real output is
not significant in the case of the index of average denomination.
However, the behavior of real output and rice output in equations
14 and 15 are seen to be important in the case of the wholesale price
index. According to equations 14 and 15, prices will decline with an

equal percentage increase in money supply and real output, since the

 

 

XII

sizes of regression coefficients of the index of real output and rice
output are greater than that of the index of money supply. This may
happen because of the high inter-correlation between the independent
variables.2 This high intercorrelation reflects the fact that much
of the farming and industrial production is financed by bank funds.

The high intercorrelation does not eliminate the importance
of the signs of the regression coefficients. Therefore, it appears
to be that an increase in industrial output or in rice output has a
strong tendency to dampen the general price level according to the
wholesale price index. The partial correlation coefficients for
real output and rice output are -.8917 and -.4899 respectively. The
former coefficient is very significant and the latter coefficient is
significant at the 10 per cent level. This observation indicates
that the wholesale price index is very sensitive to increases in
real output.

In the case of the index of average denomination money supply
is the only variable that is significant in both natural numbers
and logarithms. The other variables are insignificant. This indi—
cates that the index of average denomination is less sensitive to
changes in real output.
B. An Alternative Comparison of Indices

The most important observation in this test seems to be the

 

2The intercorrelation coefficient between the money supply
and real output (equation 14) is .8956; between the money supply
and rice output (equation 15) is .5515.

 

7 U
.
P . 2 , , -
7 l l -
o i .
g . \- . . .
. - , .
I
g 4 » . .
- _ _ . c - . I
. r , 1
, 9
a _ , _ r g
g ..
. . a
I, I ..
4' J ’ . 4

 

 

 

XIII

fact that the two price indices are different in nature.3 The index
of average denomination reflects price changes in the money sector

of the Korean economy, while the wholesale price index reflects the
changes of wholesale prices in Seoul. It is entirely possible to

have a relatively sensitive relationship between the increase in

real output and prices in Seoul, where much of the farm and industrial
output is channeled, while the general price level of the total
economy is insensitive to changes in real output as the index of
average denomination shows. This is especially true because of the
imperfectness of markets in areas other than Seoul. .

The problem of this study is that of inflection in Korea,
not in Seoul. Therefore, the index of average denomination is pre-
ferable to the wholesale price index. It should be cautioned that
it is not possible to interpret the Seoul Wholesale Price Index as
the general price level of the whole economy. When one treats the
index of Seoul wholesale prices as the index of the price level of
the whole economy, the interpretation is bound to be misleading.

The annual average of the money supply and the two price indices

are shown in the following table:

Mbney Supply Index of Seoul Index of Average

 

 

 

(in million hwap) wholesale gpices D-epominatipp lndeg of GNP‘
1946 183.6 66.3 59.8 1
1960 292,081,: 25,8735 52.51233 g

1,136 times 392 times 878 times 2 times

3The writer is indebted to Professor John M. Hunter for this
jpoint.

 

 

XIV

The indices of variables indicated above can be arranged in the
equation of the quantity theory, MV 2 PT. The behavior of velocity
in 1960 can be speculated upon by studying the residuals after the

indices of 1960 are arranged in the following equations:

.11. .1. .2. .2.
1,136X (1.54) : 878 x 2 (1)

11136x (0685) - 392 X 2 000 (2)

The index of the money supply and real output are arranged with the

index of average denomination in equation (1) and with the index

of the Seoul wholesale prices in equation (2). In equation (2),
velocity declined about 31 per cent from 1946 to 1960, while velocity

increased about 54 per cent during the same period in equation (1).

In view of the fact that velocity can not possibly decline

in a period of war, prolonged inflation and political instability,

it is not proper to use the wholesale price index as the price index

of the whole economy. This provides clear evidence that the index

of average denomination is preferable to the Seoul Wholesale Price

Index for the purpose of this study. It is misleading to say that

the circulation of money either in Seoul or in Korea declined between

1946 and 1960. If this is what the Seoul Wholesale Price Index ‘

implies, the index is clearly a misleading one.

C. The Behavior of Velocity

For the above regression analysis to be meaningful, the

 

4See Chapter C, Appendix. It is shown that the real output of
goods and services did not increase more than two times from 1946 to 1960.

 

o - .
1’

\ , "D \ '

\ , 0A. _ ‘ O
1

". V .
,..
. . J'l
. ~l .

a
o
1
O '
1

 

 

XV

behavior of velocity is crucial. Suppose that the index of average
denomination increased 9 per cent and the wholesale price index
increased 5 per cent as money supply and real output increased 10

per cent and l per cent respectively. With the assumption of constant
velocity, the former price index can be considered a better index

than the latter because the difference of the percentage changes
between the money supply and real output should be equal to the
percentage changes of prices. However, if velocity were not constant,
but declined 4 per cent, the above inference would be misleading.

Only if velocity is reasonable constant will the above test be valid.

Since the data for computing velocity, the national income
divided by the total money supply, are not available in Korea, a
possible way of studying the behavior of velocity is through some
indirect method. The behavior of deposit velocity is used as the
basis for studying the behavior of the velocity of money in this
section. Data for the deposit velocity are available in Korea after
1952.

In Chapter V, the quarterly changes in the deposit velocity
are shown to be positively related to changes in money supply.
Moreover, the seasonal behavior of deposit velocity is found to be
more fluctuating than that of money supply. The fact that the
seasonal behavior of the deposit velocity is fluctuating should not
mislead one to think that the secular behavior of deposit velocity
is also fluctuating.

In Chart A, the seasonally adjusted data on the changes in the

index of money supply and the level of deposit velocity from 1952 to

 

80

 

 

 

Z?

 

 

 

 

 

 

 

 

 

 

EN
0 \
l
\
3 ‘ 9#/2
“/zxz ‘
v I _' Ira vuv yum-«u... ....-- D .. ‘11. mm

 

seasonally adjusted data presented below.

XVI

1960 are presented. During 1952, however, the deposit velocity more
than doubled: from 6.97 in March to 14.72 in December, 1952. The
reason for this rapid increase is difficult to understand. An
extensive substitution of deposits for notes because of the anticipa-
tion of need for cash, as explained in Chapter VI, may have been a
cause of this increase. Perhaps the most important reason might
have been the fact that checks were not a pepular medium of exchange
until the middle of 1951 at the earliest. During the Korean war,
the public had practically stepped using checks. Therefore, the low
base period makes the rate of change great. This is more true be—
cause trade, domestic and otherwise and manufacturing activities
were very vigorous in 1952.

At the end of 1952 the deposit velocity was 14.72. It in-
creased to 1961 at the end of 1960, a very slight change. At any
rate, it may be fair to say that deposit velocity increased less than
twofold during the 9 year period. This increase, however, is not
significant compared to the twenty-four fold increase in money supply.

The big decline of deposit velocity in the first quarter of
1953 largely reflects the consequence of the blocking of deposit
accounts undertaken during the currency reform of 1953. Therefore,
the period prior to the currency reform cannot be connected with the
period after the reform. With the exception of the first quarter of
1953, and the year of election and the student revolt of 1960, the
behavior of deposit velocity over the period appears to be relatively
constant. This can be seen more clearly by the annual averages of the

seasonally adjusted data presented below.

'T'

XVII

The AnnualHAverage of Deposit Velocit LSeasonally Adjusted

1952 ... 10.68 1956 ... 11.25
1953 ... 7.68 1957 ... 11.10
1954 ... 8.84 1958 ... 10.99
1955 ... 10.14 1959 ... 11.19

1960 ... 14.03

In order to see the relationship between the changes in
money supply and deposit velocity, a simple correlation analysis is
made. When the quarterly data of deposit velocity are run against
the quarterly changes in money supply, the correlation coefficient is
-.0022. When the quarterly changes in deposit velocity are run against
the quarterly changes in money supply, the correlation coefficient is
-.0035. In either case, the correlation coefficients are not signifi-
cant at all. The correlation coefficient between the percentage
change in the annual average of deposit velocity is shown to be -.l932.
In order for the correlation to be significant at the 10 per cent level
with 8 observations, the coefficient should be .621. These results
indicate no evidence of a relationship between the money supply and
the deposit velocity.

Cagan argues that velocity is a function of changes in prices
during a period of hyper-inflation.5 The annual change in prices
in Korea is about 60 per cent, a very high rate though it is not
hyper-inflation. A simple correlation analysis was run between the

percentage changes in the annual average of deposit velocity, using

 

5 Phillip Cagan, "Dynamics of Hyper-inflation," ed. Friedman,
Studies in the anntity Theory of Money (Chicago: University of Chicago
Press, 1956), Pp. 25"1170

o as. a no:
a o c ' ‘3‘
o ...-r o I.-
-. .h. g I no. ‘
a nun
.
o
p
o I
I 0 , I
I
o
n I '
|
o
I
I
,
\
.
. . , .
.
‘ .
a - '\

 

XVIII

both the wholesale price indice and the index of average denomination.
The correlation coefficient were .2863 and .29256 respectively. In
order for the correlation to be significant at the 10 per cent level
with 8 observations, the coefficient should be .621. These results
also indicate no evidence of a relationship between deposit velocity
and price changes.
The above results clearly indicate that there is no evidence

of a relationship between deposit velocity and either money supply
or price changes. The velocity of demand deposits is usually less
stable than that of the total money supply. This is especially true in ‘
the case of Korea because about 50 per cent of total national income
acrues to the agricultural sector.

In agricultural countries where peasants readily hoard

money, an inflation, especially in its early stages,

does not raise prices preportionally, ... more money

flows into the pockets of the peasants, it tends to stick

there; deeming themselves that much richer, the peasants
increase the proportions of their receipts that they hoard.

7
Fisher also states that "an increased trade in the southern states,
where velocity of circulation is presumably slow, would tend to

lower the average velocity in the United States."8 Notes, rather

than checks, are used in the agricultural sector. It is important

to observe that the use of notes not only tends to<de¢rea3e the -‘

 

6 J. M. Keynes, A_I:gg§_2f Monetary Reform (London: MacMillan
Co., 192%), p. 81.
The year of currency reform, 1953, is excluded from the
computation.
Irving Fisher, The Purchasing Power g: Money (New York:
Macmillan Co., 1911), p. 166.

 

 

IXX

the average velocity of the total money supply, but also make the
behavior of velocity stable.

A similar contention is also fo und in a study made by
Professor Bloomfield, a noted eXpert on central banking in under-

developed countries.

Although all too litttle is known about the behavior of
money in underdeveloped countries, there is reason to
believe that the income-velocity of money in such countries
tends, in the short run at least, to be much more stable
than in developed ones. This stems from the fact that
holdings of inactive money balances tend to be relatively
small ( although in some Far Eastern countries a substantial
amount of currency may be hoarded), or at lea t are not
subject to large or sudden short-run shifts.

It has been argued that the behavior of total velocity
would be more stable than that of deposit velocity. Therefore, the
magnititudes of changes in deposit velocity will certainly overstate
the actual behavior of total velocity.

In this connection, a peculiar development of the money
supply should be mentioned. The value of notes increased about
1,659 times, while the value of deposits increased 1,245 times from

1945 to 1960, as shown in the following table.10

 

 

Notes Deposits Note/Deposits
( In Million Hwan )
1945 84 29.7 2.8

1960 139,319 37,ooo.o 3.8

 

Changes: , 1,656 times 1,246 times

 

9Arthur I. Bloomfield, "Monetary Policy in Underdeveloped
Gountries," Public Policy, A Yearbook of the Graduate School of Public
Administration ( Harvard University Press, 1956), Vol. VII, pp. 241-2.

10Ban} of Korea, The Economics Statistics Annual, 1961, p.28.

 

XX

Several observations can be made about the information above.
Notes have been an increasingly important factor in the total money
supply. Thus, the ratio of notes to deposits increased over the
period, indicating that deposits have been increasingly used in
less preportion to the total money supply. The fact that the per-
centage change in the number of dishonored checks increased from
0.35 per cent in 1945 to 1.7811 per cent of the total number of
checks in 1960 may eXplain the above situation. Also, the tight
monetary policy implemented in terms of the loan ceiling policy was
mainly concentrated in restricting the eXpansion of private checking
deposits. Then how can the 1,246-fold increase in the value of
deposits be explained? To a large extent, checks may have been used
primarily in business circles, particularly big businesses which
had close connections with banks. Bank loans are made in the form
of checks to business concerns. This deveIOpment must have made the
velocity of deposits more sensitive than otherwise. This sensitive
behavior of deposits may be relatively unimportant when it is
viewed with the economy as a whole.

The above argument seems to lead to the conclusion that
behavior of velocity in Korea was relatively constant over the period
of this study. This conclusion comes close to Friedman's contention.

True, the ratio of money income to the stock of money,...
is not by any means a numerical constant, either for
different countries or over times. However, in any one
country it generally changes relatively little from

year to year except under circumstaniss of extreme
instability such as hyper-inflation.

 

11 Ibid., p. 81.
12 Milton Friedman, 'Mbnetary Data and National Income Estimate,"
Economic Develgment and Cultural Change, IX No. 3, April, 1961, p. 267.

 

 

 

 

 

CHAPTER C
INDICES OF REAL OUTPUT

In the regression analysis presented in Appendix B, the
index of industrial production was used as the index of real output.
From 1946 to 1954, a crude index based on 12 major commodities, includ-
ing rice output, was connected to the index of industrial production
published by the Bank of Korea. The reason for including rice output
in the index was to eliminate the upward bias of the index which would
occur with only 11 representative commodities. The index shows roughly
a threefold increase of real output from 1946 to 1960. This index
compares favorably with the index of coal consumption.

A very crude index of gross national output is estimated
for the purpose of this study. All indices of real output computed in
this study are only rough estimations to help gauge the over-all level
of real output.

Annual data for national income is published by the Bank
of Korea from 1953 on. The reliability of this data is questionable.
Prior to 1953, several attempts were made to estimate the gross national_
product. For example, the Nathan Report published ”Gross National Prod-
-duct in ROK Fiscal Years, 1949-50 and 1953-1951.."1 The Natham.Report,
however, explicitly warns that this estimate is less adaptable to the

analysis of inflation. The estimation was made for the purpose ofth?i031
_programming.

+

1 UNKRA. An Economic Programme fog;Korean Reconstruction
(”Prepared for UNKRA by Robert R. Nathan Associates, Inc.” New York:
UNKRA, 1951.), pp. 436-451..

XXI

 

WHIM‘I‘ “WA .3 he " “o -
.K‘ . .
| A

l

XXII

GNP data from 1953 to 1960, published by the Bank of Korea,
is connected with Nathan's estimation in Index 1. ( See: Table C )
Nathan's estimate was made on the U.S. dollar at 1953-52 prices, while
the Bank of Korea data for GNP was based on the 1955 prices of Korean
currency. In order to maintain the consistency of both data, Nathan's
estimate is converted into hwan value, by multiplying his figures by
500 hwan, the exchanges rate which was effective in 1955. Practically
the same result was obtained by multiplying Nathan's 1952 and 1949 figures
in Table C by the ratio of its 1953 figures over the BOK's 1953 figures.
Index 2 is a crude measure of GNP computed by the writer on
the basis of the quantity index of 33 major commodities in agriculture,

mining, manufacture and electricity as follows:

 

Weight Adjusted Weight
1. Agriculture
40 % 71.7%
2 commodities
2. Mining 1.1% 1.9%
6 commodities
3. Manufacturing 14.4% 25.8%
24 commodities
4. Electricity ,fiz ‘ ,532
55.8% 100%

In the table above, weight is the average value, at 1955 prices,
accrued to respective sector in the GNP of 1953, 1954 and 1955. This
index is no different from the index of industrial production except

for the adjustment of weights. By adjusting weights for the respective

XXIII

sector of economy. However, this index reflects real output of goods.
and services, rather than industrial production.

Sectors other than agriculture, mining, manufacture and
electricity comprise roughly 44 per cent of total economic activity,
other sectors being trade, utilities, government services and other
services. It is assumed that the services of these other sectors
are shared by agriculture, mining, manufacture and electricity in
preportion to their respective weights. For example, two commodities
in agriculture represent 40 per cent of the total gross national
product. In our adjusted weights, the agricultural sector contri-
butes additional income of 21.7 per cent for service sectors. That
is to say, the agricultural sector not only provides 40 per cent of the
total income directly in terms of farm output, but also creates
income for service sectors closely related with agricultural pro-
duction. In this way, the measure of goods and services can be
established.

Index 1 and Index 2 both indicate that real output

in Korea roughly doubled from 1946 to 1960.

 

 

 

 

 

 

TABLE C
INDICES OF REAL OUTPUT

«l

 

(in bins: h...) in? index 2 “is it?"
GNP Industrial Coal
1946:100 1946:100 Production Consumption
1955:100 19555100
1946 (625.2)“ 100 100 40.9
1947 112.5 48.0 56.2
1948 131.8 61.2 75.7
1949 (893.1)* 142.3 139.6 70.2 68.5
1950 131.0 60.8 43.1
1951 100.8 48.5 40.4
1952 (698.4)* 111.7 99.0 55.2 51.6
1953 868.5 138.9 143.9 81.2 65.1
1954 913.5 146.1 161.8 93.1 77.9
1955 950.2 151.9 168.3 100 100
1956 952.8 152.4 159.5 104 112.8
1957 1,035.3~ 165.6 189.0 134.9 132.8
1958 1,107.0 177.1 200.9 132.4 144.9
1959 1,164.8 186.1 209.3 140.5 171.5
1960 1,192.3 190.7 207.9 142.9 233.0

 

Sources: For GNP index, from.Nathan's Report for 1949,1952 and 1953,
for rest of years from Economics-Statistics Annual, 1961
(Bank of Korea, 1961), pp. 10-11. Data for all other indices
are from the Egonomic Annual, 1955, 1956, 1957, 1958, 1959
and 1960.

* Nathan's figures are converted into hwan value
** Hwan values are estimated on the basis of Index2

XXIV

 

 

CHAPTER D
NOTE ON RELATIONSHIP BETWEEN REAL OUTPUT AND NUMBER OF NOTES

One of the most instructive comments Professor Lerner made
on my thesis is his conclusion that changes in the number of notes
measure changes in real income or the real value of the stock of money.
"The increase in the number of units of currency which is equal to
the increase in the real value of the money stock will therefore be
equal to the increase in the real national income. This comes to an
increase of by a factor of 12 over the 15 years and this seems to
be much greater than is plausible.”1
Professor Lerner drew the above conclusion from statistics of
average denomination presented in the appendix of my thesis. The
suggestions he made are greatly appreciated because they provide a
new insight, with some modifications, on the measurement of real
output in an underdeveloped country. Friedman suggests the use of
monetary data as the national income estimate.2
Professor Lerner's conclusion is very important. It is true
that real income will seldom increase by 12 times in 15 years in any

Country, especially Korea. If so, the conclusion drawn by Professor

Lerner implies either that the index of average denomination is not

 

lAbba P. Lerner, Rough Notes on Chungjs Thesig. June 4, 1962. p.2.

2Milton Friedman, "Menetary Data and National Income Estimate,”
Economic Deve10pment and Cultural Change LX, No. 3, April, 1962. pp. 267-
286.

XXV

 

 

IIDII

thn

"‘vll \eé.

XXVI

an accurate measure of price changes or that velocity, which is argued

to be constant in my thesis, has not been constant.3
The purpose of this paper is to demonstrate that Professor

Lerner's conclusion is not applicable to my thesis. Professor Lerner

states:
Very fundamental is the assumption of a constant velocity of
circulation,... As it stated and if it is assumed that the index
of average denomination is correct in measuring the price level,
then the increase in the number of notes over the period would be
a measure of the increase in real income. This is because the
increase in the number of notes multiplied by the increase in
the average denomination gives increase in the nominal value of
notes._ If the increase in denomination is an accurate measure of
the increase in thegprice level, then deflating the nominal
increase in money_by the increase in thegprice level which would
give us the increase in the real value of theJmoney stock becomes
egual to the increase in the number of notes.4
The first part of the above underlined statement infers that,

dN X d(Ad) : dM

Does the increase in the number of notes multiplied by the increase in

the average denomination give the increase in the nominal value of

notes? It does not. The following example is made in such a way

that the number of notes measures real output. Velocity is constant

and the average denomination reflects price changes accurately. An

assumption implicit in this example is that the total money supply

is composed solely of currency.

 

3My contention of relative constant velocity does not mean that
velocity has been numerically constant during 1952 and 1960 in Korea. The
behavior of velocity is shown to be relatively constant during this period.
If this is true, I think that velocity is not a crucial factor for the
purpose of my study. However, I am fully cognizant of Professor Lerner's
suggestion that it is necessary to make certain adjustments especially
because the period prior to 1952 was the period in which the behavior
of velocity was not stable.

4Lerner, pp; cit,, pp. 1-2. (underlines are provided by the writer)

 

.1. .u. .1. .14. .11. .2. _T..
0 $2 10 $20 1. $1 20
1 $4 10 $40 1 $2 20
2 $5 12 $60 1 352.5 24
3 $5 20 1. $100 1 $2.5 40
Observe the following figures:
.19. (11112.). .011. .5311.
1 - 0 32 x 0 $20
2 - 1 31 X 2 )1 $20
3 - 2 250 x 8 7‘ $40
The above illustration clearly demonstrates that , Professor

Lerner's contention should be reformulated as follows;
(N.Ad )= M
d( N. AD) = dM
N d(Ad )+AD dN = dM (1)
Equation (1) indicates that changes in nominal value of the notes are
equal to the number of notes multiplied by the changes in average
denomination, plus the average denomination multiplied by the changes
in the number of notes.

The difference between the absolute changes and the prOpertional
changes is often confusing. The above illustration is the case of the
absolute changes. If Professor Lerner means the preportional changes,
than his statement is true. That is, if N increases by a factor of 3
and AD increases by a factor of 2, then M increases by a factor of 6.

It may be worthwhile to examine Professor Lerner's conclusion
in terms of the equation of the quantity theory. I do realize that he

infers a relationship between the number of notes and real income or the

XXVIII

real value of the money stock. To be specific, he states that the
increase in the number of units of currency, which is equal to the
increase in the real.va1ue of the money stock, will be equal to the
increase in real income. This conclusion may be derived from following
argument. The Fisherian equation can be written as,

(AD - N)V=P . T

And AD equals p,
(AD . N)V=AD -T

T
then, N V 3 T, or V = ‘fi‘

d N = d T, if V equals 1.
In the above illustration, an error is made.in treating AD
as equal to p. It is impossible to do so because they are not the same
things. Because of this, the increase in the number of notes is not
equal to the increase in real income. This will be shown by the
following illustration.

Let us define the index of average denomination.

 

AD = Total value of currency ... (2)
No. of notes
(Ad . N) = Total value of currency ... (2a)

The price at t(l) is,

 

Pl : ADl: when r = ..122__, because P19- - .3231... (3)
r Po '—T§: - ADo ...

Substituting equations (2a) and (3) into the Fisherian equation,

AD
(ADl'Nl)V =—.TL.T1

N1 ( V r ) = T1 000 (4)

XXIX

Equation (4) indicates that there is a preportional relationship between
N1 and T1. ( V r ) being constant, N1 measures T1 and thus ..1Ll..

 

P1
That is, N1 at ._._;1l , but
1
Nlr = M1
P1

The prOportional relationship between the number of notes and

real income can be explained in another way.

( AD 3 N ) v : P°T

or
’w=+<§)-P
The above equation indicates that there must be a preportional rela-
tionship between T and N for the average denomination to be a perfect
index of price changes.

The contention of equation (4), that there is a prOpertional
relationship between N and T, is based on the assumption that the total
money supply is composed solely of currency. When this assumption
is removed, the contention does not hold true. The number of notes
fails to measure real income and the real value of the money stock.

The Fisherian equation can now be written as:
M? V' +- MP V' = P T
1 M1 V' ... Transactions carried out
by notes.

M? V" ... Transactions carried out
by checks.

 

-.
n
.
I
I
n
r
I
I v
1
u
i
at.
q
..-
a

 

If v.1 : val = V0,

 

 

v ( AD'l - N'l 0» AD"1 v N"1 ) = A21 ° T1
IfAD'l = AD"1 ‘ ADI:
ADlV ( N"+ N" ) = A31 - T1
v r ( N'l -+ N"1 ) = T1 ... (5)5

In equation (5), it is indicated that N. (the number of notes)
alone cannot measure T. Only if N" (the number of checks) stays

constant will changes in N' measure T only under the two assumptions

that V' : V", and AD' = AD”. Once again here is a prOportional
relationship between the number of notes and real output assuming

N" stays constant.

N' - T - N"
V r

dN' = dT 3 if N" is constant.

Vr
If N" is not constant,

 

dN' = dT _ (mu6

1'

 

5The total clearing of checks is equal to Mvv", the total

clearing of checks divided by the amount of demand deposits will give
us a velocity of deposits. The amount of deposits can be conceived
as ( AD” . N“ ). It was assumed that v'l - val - v0 and AD'l - AD”1
I ADo in deriving equation 5. The assumptions are extremely unrealistic,
but serve the purpose of establishing the prOportional relationship
between the number of notes and real output.

ofessor Victor Smith suggests an interesting point. If N"=kN',
k being constant, (This is a famous statement of Fisher. See: Irving Fisher,
The Purchaging_Power of Money(19ll)See the passagen on P.52: "Both money in
circulation ... and money in reserve ... tend to keep a fixed ratio to
deposits ... If that ratio is disturbed temporarily, there will come into
play a tendency to restore it. “) changes in N' and T are in the same
prOportional relationship. Tl

“'1 +~ k “'1 “V‘f”

_ T]
N' 1 + k - .1-.._.
1 ( ) Vr
T1
v r ("lek )

 

N11

 

 

XXXI

The number of deposits is very likely to change in any country. There-
fore, changes in the number of deposits should be deducted from the
right side of the equation. Even doing this seems to be very unreal-
istic because the two assumptions mentioned are required. In an
economy in which deposits are included in the total money supply,
therefore, the relationship between the number of notes and real

output becomes very obscure. In the case of an underdeveIOped country
in which there are no deposits or the number of depbsits is constant,
Professor Lerner's suggestion contributes greatly in the measurement

of real output.

Let us observe the following example;

 

 

 

 

t AD' N' v' M'V' AD" N” v" M"V" 14v .; _I_’_
0 $5 3 1 $15 $5 1 2 $10 $25 ; .. $1..
1 $6 4 1 $24 $36 1.2 2 $14.4 $38.8 $1.2
2 $7 5 1 $35 $7 1.3 2 $18.2 $53.2 $1.4
3 $8 6 1 $48 $8 1.4 2 $22.4 $70.4 $1.6

In the above example, the note/deposits ratio increases, as in
the case of Korea.7 The velocity of notes is not equal to that of
deposits, but both are constant. AD' and AD“ are equal and AD cor-
rectly measures the price changes. It must be noted that N' rose two

times from t(O) to t(3), but T did not rise by two times. The point

25
32
38

 

7 The notes/deposits ratio increased from.2.8 per cent in 1945 to

3.8 per cent in 1960 in Korea. (Deposits include private checking accounts,
and accounts of local governments and others which are defined as the parts

of the money supply.)

   

 

 

XXXII

of this illustration is that the number of notes alone cannot measure
real output. It will be expected that we will have further distortion
if AD' and AD" are not equal. Thus it is safe to say that the pro-
portional relationship between the number of notes and real income does
not hold when deposits are taken account of in the total money supply.
Professor Lerner states that the number of notes thus the real
value of the money stock increased by a factor of 12 over the last 15
years in Korea, This seems to be an incorrect estimate for the reasons
explained above. When the nominal stock of money is deflated by the
index of average denomination and the index of the Seoul wholesale
prices, the real value of the money stock increased only 5 per cent
and 133 per cent respectively between 1946 and 1960. In the previous
chapter it was also shown that real output roughly doubled from
1946 to 1960.

‘-
r“
3"

Room USE 0.

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