## _wp03250 — Appendix Figures

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### III. Results — Key Findings on Deflation Dynamics
- Over 1998: Q4–2002: Q3 the decline in the price level is associated with declines in both transitory and permanent components; most of the fall between 2001: Q3 and 2002: Q3 is accounted for by the permanent component.
- Permanent shocks determine the path of the permanent component and have substantial impact on the transitory component.
- Permanent shocks contribute 44 percent of price fluctuations at the short term (one quarter) and 94 percent at the long term (forty quarters).
  - Productivity shocks and shocks related to changes in the aggregate money supply and price equalization with trading partners account for 34 percent and 60 percent of the long-term fluctuations in prices, respectively.
  - In the short (one quarter) and medium term (12 quarters), productivity shocks account for 39 percent and 44 percent of price fluctuations, respectively.
- Transitory shocks account for about 56 percent of price fluctuations in the short term, declining to about 35 percent in the medium term.
  - Cost-push shocks explain about 55 percent of short-term price fluctuations and about 13 percent in the medium term.
  - Aggregate demand shocks explain about 16 percent of medium-term price fluctuations.
  - Liquidity-preference shocks explain about 6 percent of medium-term price fluctuations.
- For output:
  - Permanent shocks contribute 55 percent of output fluctuations in the short term and about 93 percent in the long term.
  - Real shocks (productivity) and nominal shocks (money supply/price equalization) explain 88 percent and 5 percent of long-term output fluctuations, respectively.
  - In the short term, real shocks explain 44 percent and nominal shocks 9 percent of output fluctuations.
  - Transitory shocks explain 48 percent of short-term output fluctuations, declining to about 22 percent over the medium term.
  - Aggregate demand shocks explain about 48 percent of short-term output variability, declining to about 11 percent over the medium term.
  - Cost-push shocks account for about 8 percent of medium-term output variability; liquidity-preference shocks about 3 percent.

### Dynamic Responses (Impulse Responses) — Direction and Timing
- Responses of prices to shocks align with standard theory:
  - Temporary positive real (productivity) shock -> permanent decrease in prices and increase in output.
  - Temporary negative aggregate demand shock -> short-run fall in prices, potential increase in real wages and unemployment if wages are downward sticky; prices revert in the long run under identification assumptions.
- Adjustment speed of prices to transitory shocks (maximum effect reached):
  - Aggregate demand shock: maximum after seven quarters.
  - Cost-push shock: maximum after four quarters.
  - Liquidity-preference shock: maximum after eight quarters.
- Half-life estimates for deviations from purchasing power parity:
  - Cost-push shock: about eight quarters for half the effects to disappear.
  - Aggregate-demand shock: about 12 quarters for half the effects to disappear.

### IV. Interpretation — Drivers and Policy Implications
- The prominence of permanent shocks (productivity, money supply/price convergence) likely reflects:
  - Increased integration between Hong Kong SAR and the mainland.
  - Scarce money supply over the period examined.
- Downward pressure on prices could continue because:
  - Price differentials between Hong Kong SAR and mainland cities such as Shenzhen and Guangdong remain substantial.
  - The stance of U.S. monetary policy could tighten when the U.S. economy recovers, affecting Hong Kong under the linked exchange rate.
  - Wage differentials between Hong Kong SAR and mainland cities have not narrowed substantially, supporting continued convergence.
- Limited contribution and duration of aggregate demand shocks (e.g., temporary fiscal measures) imply:
  - Expansionary fiscal policies may be unlikely to have a significant direct effect on price developments, given a narrow tax structure and limited fiscal multiplier in Hong Kong SAR.

### V. Conclusion — Summary of Mechanisms
- Permanent shocks (productivity and nominal shocks including money supply and price convergence) have become more important in explaining deflation.
- Deflation originates partly from the real side (productivity changes) and partly from the monetary side (scarce money supply, purchasing-power-parity adjustment).
- Temporary shifts in aggregate demand have been perpetuated by negative wealth and balance-sheet effects from asset-price declines over the past five years.
- There is a prevalence of productivity and nominal shocks in explaining price and output fluctuations.

### I & II. Framework and Model Overview
- Model: Structural vector error correction model (common trends model, CTM) à la King and others (1991) applied to five variables:
  - Real output (nominal GDP deflated by composite CPI), broad money (HK$), CPI, real asset prices (Hang Seng stock index deflated by CPI), and foreign prices in HK$ (trading partners CPI expressed in HK$).
- CTM features:
  - Decomposes each series into permanent and transitory components.
  - Identifies structural shocks using theory-based restrictions: stable money demand, purchasing power parity, and arbitrage between output and real stock prices.
  - Distinguishes permanent shocks (real/productivity shocks and changes in the money supply/price convergence) from transitory shocks (cost-push, aggregate demand, liquidity-preference).
- Identification restrictions imposed:
  - Long-run neutrality of money: permanent nominal shock does not affect real GDP in the long run.
  - Short-run restrictions: (i) cost-push shocks do not have an immediate impact on output; (ii) liquidity preference shocks do not have an immediate impact on output and domestic prices.

### Appendix — Technical Details and Estimation Results
- Sample: 1980 Q4–2002 Q3. Data source: CEIC database.
- Variables expressed in natural logarithm and grouped into xt = [yt, ft, mt, pt, e*p]′ with stochastic trends tτ including a real stochastic trend tθ and a nominal stochastic trend tβ.
- Estimation steps: unit-root tests, Johansen cointegration, theory-based identification, impulse-response analysis, variance decomposition.
- Unit root tests: Augmented Dickey-Fuller could not reject unit roots for all variables.
- Johansen cointegration test indicates three cointegrating relationships.
- Theoretical cointegrating vectors (Money Demand, PPP, Arbitrage) could not be rejected; estimated coefficients consistent with theoretical predictions (Table A2 reported a χ2 statistic of 4.98 for tested restrictions).
- Impulse-response summaries from Appendix figures:
  - Productivity shock: permanent increase in output, real stock prices, money supply; permanent decline in price level.
  - Permanent nominal shock: transitory/persistent effects on real variables, permanent effects on nominal variables; output increases temporarily after a small initial fall.
  - Liquidity-preference shock: short-lived positive effects on output reversed after six quarters; temporary gradual increase in price level and decline in broad money.
  - Cost-push shock: temporary reductions in output, real stock prices and broad money; temporary rise in prices.
  - Aggregate-demand shock: increases in output and price level; declines in real stock prices and broad money.
- Figures A6–A7 present decompositions of domestic and foreign prices, output, real stock prices, and broad money into actual, permanent, and transitory components to identify periods associated with productivity-driven deflation, insufficient money, or negative investor sentiment.

*IMF staff estimates; Appendix Figures from _wp03250 - Appendix Figures.*

### References..............................................................................................................

### _wp03250 - References

### Tables
- 1. Contributors to Deflation .......................................................................................................3
- 2. Economic Indicators ..............................................................................................................3
- 3. Forecast Error Variance Decomposition..............................................................................11

### Figures
- 1. Effects of Shocks on Prices....................................................................................................7
- 2. Prices: Actual and Permanent and Transitory Components ..................................................8
- 3. Transitory Component of Prices: Contributions of Transitory Shocks .................................9
- 4. Year-on-Year Inflation Rate: Actual and Permanent and Transitory ....................................9
- 5. Movements in the Price Level in Response to Different One-Time Shocks .......................13

### Appendix
- I. Technical Details ..................................................................................................................15
- A. Methodology ...........................................................................................................15
- B. Results .....................................................................................................................17

### Appendix Tables
- A1. Cointegration Test.............................................................................................................17
- A2. Test of Theoretical Cointegrating Vectors........................................................................18

*Source: _wp03250 - References..............................................................................................................*

### Appendix Figures

### Appendix Figures (_wp03250)

### III. Results — Key Findings on Deflation Dynamics
- Over 1998: Q4–2002: Q3 the decline in the price level is associated with declines in both transitory and permanent components; most of the fall between 2001: Q3 and 2002: Q3 is accounted for by the permanent component.
- Permanent shocks determine the path of the permanent component and have substantial impact on the transitory component.
- Permanent shocks contribute 44 percent of price fluctuations at the short term (one quarter) and 94 percent at the long term (forty quarters).
  - Productivity shocks and shocks related to changes in the aggregate money supply and price equalization with trading partners account for 34 percent and 60 percent of the long-term fluctuations in prices, respectively.
  - In the short (one quarter) and medium term (12 quarters), productivity shocks account for 39 percent and 44 percent of price fluctuations, respectively.
- Transitory shocks account for about 56 percent of price fluctuations in the short term, declining to about 35 percent in the medium term.
  - Cost-push shocks explain about 55 percent of short-term price fluctuations and about 13 percent in the medium term.
  - Aggregate demand shocks explain about 16 percent of medium-term price fluctuations.
  - Liquidity-preference shocks explain about 6 percent of medium-term price fluctuations.
- For output:
  - Permanent shocks contribute 55 percent of output fluctuations in the short term and about 93 percent in the long term.
  - Real shocks (productivity) and nominal shocks (money supply/price equalization) explain 88 percent and 5 percent of long-term output fluctuations, respectively.
  - In the short term, real shocks explain 44 percent and nominal shocks 9 percent of output fluctuations.
  - Transitory shocks explain 48 percent of short-term output fluctuations, declining to about 22 percent over the medium term.
  - Aggregate demand shocks explain about 48 percent of short-term output variability, declining to about 11 percent over the medium term.
  - Cost-push shocks account for about 8 percent of medium-term output variability; liquidity-preference shocks about 3 percent.

### Dynamic Responses (Impulse Responses) — Direction and Timing
- Responses of prices to shocks align with standard theory:
  - Temporary positive real (productivity) shock -> permanent decrease in prices and increase in output.
  - Temporary negative aggregate demand shock -> short-run fall in prices, potential increase in real wages and unemployment if wages are downward sticky; prices revert in the long run under identification assumptions.
- Adjustment speed of prices to transitory shocks (maximum effect reached):
  - Aggregate demand shock: maximum after seven quarters.
  - Cost-push shock: maximum after four quarters.
  - Liquidity-preference shock: maximum after eight quarters.
- Half-life estimates for deviations from purchasing power parity:
  - Cost-push shock: about eight quarters for half the effects to disappear.
  - Aggregate-demand shock: about 12 quarters for half the effects to disappear.

### IV. Interpretation — Drivers and Policy Implications
- The prominence of permanent shocks (productivity, money supply/price convergence) likely reflects:
  - Increased integration between Hong Kong SAR and the mainland.
  - Scarce money supply over the period examined.
- Downward pressure on prices could continue because:
  - Price differentials between Hong Kong SAR and mainland cities such as Shenzhen and Guangdong remain substantial.
  - The stance of U.S. monetary policy could tighten when the U.S. economy recovers, affecting Hong Kong under the linked exchange rate.
  - Wage differentials between Hong Kong SAR and mainland cities have not narrowed substantially, supporting continued convergence.
- Limited contribution and duration of aggregate demand shocks (e.g., temporary fiscal measures) imply:
  - Expansionary fiscal policies may be unlikely to have a significant direct effect on price developments, given a narrow tax structure and limited fiscal multiplier in Hong Kong SAR.

### V. Conclusion — Summary of Mechanisms
- Permanent shocks (productivity and nominal shocks including money supply and price convergence) have become more important in explaining deflation.
- Deflation originates partly from the real side (productivity changes) and partly from the monetary side (scarce money supply, purchasing-power-parity adjustment).
- Temporary shifts in aggregate demand have been perpetuated by negative wealth and balance-sheet effects from asset-price declines over the past five years.
- There is a prevalence of productivity and nominal shocks in explaining price and output fluctuations.

### I & II. Framework and Model Overview
- Model: Structural vector error correction model (common trends model, CTM) à la King and others (1991) applied to five variables:
  - Real output (nominal GDP deflated by composite CPI), broad money (HK$), CPI, real asset prices (Hang Seng stock index deflated by CPI), and foreign prices in HK$ (trading partners CPI expressed in HK$).
- CTM features:
  - Decomposes each series into permanent and transitory components.
  - Identifies structural shocks using theory-based restrictions: stable money demand, purchasing power parity, and arbitrage between output and real stock prices.
  - Distinguishes permanent shocks (real/productivity shocks and changes in the money supply/price convergence) from transitory shocks (cost-push, aggregate demand, liquidity-preference).
- Identification restrictions imposed:
  - Long-run neutrality of money: permanent nominal shock does not affect real GDP in the long run.
  - Short-run restrictions: (i) cost-push shocks do not have an immediate impact on output; (ii) liquidity preference shocks do not have an immediate impact on output and domestic prices.

### Appendix — Technical Details and Estimation Results
- Sample: 1980 Q4–2002 Q3. Data source: CEIC database.
- Variables expressed in natural logarithm and grouped into xt = [yt, ft, mt, pt, e*p]′ with stochastic trends tτ including a real stochastic trend tθ and a nominal stochastic trend tβ.
- Estimation steps: unit-root tests, Johansen cointegration, theory-based identification, impulse-response analysis, variance decomposition.
- Unit root tests: Augmented Dickey-Fuller could not reject unit roots for all variables.
- Johansen cointegration test indicates three cointegrating relationships.
- Theoretical cointegrating vectors (Money Demand, PPP, Arbitrage) could not be rejected; estimated coefficients consistent with theoretical predictions (Table A2 reported a χ2 statistic of 4.98 for tested restrictions).
- Impulse-response summaries from Appendix figures:
  - Productivity shock: permanent increase in output, real stock prices, money supply; permanent decline in price level.
  - Permanent nominal shock: transitory/persistent effects on real variables, permanent effects on nominal variables; output increases temporarily after a small initial fall.
  - Liquidity-preference shock: short-lived positive effects on output reversed after six quarters; temporary gradual increase in price level and decline in broad money.
  - Cost-push shock: temporary reductions in output, real stock prices and broad money; temporary rise in prices.
  - Aggregate-demand shock: increases in output and price level; declines in real stock prices and broad money.
- Figures A6–A7 present decompositions of domestic and foreign prices, output, real stock prices, and broad money into actual, permanent, and transitory components to identify periods associated with productivity-driven deflation, insufficient money, or negative investor sentiment.

*IMF staff estimates; Appendix Figures from _wp03250 - Appendix Figures.*

### References

### _wp03250 - References

### References
- Becker, Torbjorn, 1999, “Common Trends and Structural Change: A Dynamic Model for the 
pre- and Post-revolution Islamic Republic of Iran,” IMF working paper series, 
WP/99/82. 

- Blanchard Olivier-Jean, 1981, “Output, The Stock Market, and Interest Rates,” American 
Economic Review,” 71, pp 132–143.  

- ———, and D. Quah, 1989, “The Dynamic Effects of Aggregate Demand and Supply 
Disturbances,” American Economic Review, 79, pp. 655–673. 

- Cassola, Nuno and Claudio Morana, 2002, “Monetary Policy and the Stock Market in the 
Euro Area,” ECB working paper series, No. 119. 

- King, Richard, Charles Plosser, James Stock, and Martin Watson, 1991, “Stochastic Trends 
and Economic Fluctuation,” American Economic Review, 81, pp. 819–840. 

*Source: _wp03250 - References*

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