The substitutability of monetary assets in Taiwan.

• Author: Huang, Cliff J.

1. Introduction

   The financial sector of the Taiwan economy has experienced major structural changes in the past decade. The banking system has been liberalized, a regulated money market has developed, and the foreign exchange market has been deregulated. Nevertheless, Taiwan's financial sector is still characterized by dualism, with the coexistence of both regulated and unregulated (curb) markets. The ratio of financial loans from the unregulated market to those from the regulated market for the total private enterprise has been consistently large, averaging 27.5% for the period 1971-88.(1) Interest rates in the unregulated markets of Taiwan are generally much higher than those in the regulated markets. Figure 1 shows the disparity in interest rates between these two markets. The difference in interest rates grew during the 1970s, reaching an annual rate of 23 percent in the second quarter of 1979. Since then, the differential has declined steadily to about 17 percent in 1988.

   Because the financial loans from the unregulated market constitute a major portion of all private borrowing in Taiwan, we believe that studies of characteristics of financial markets in Taiwan should include the unregulated market as well as the regulated market. It is the purpose of this paper to extend the study of asset substitutability in Taiwan to include the unregulated financial market.

   Accurate empirical measurement of the degree of substitutability among various liquid assets is important for two distinct but related reasons. The first is the well-known Gurley-Shaw thesis [14] which relates the role of nonbank financial intermediaries to the monetary process. According to this view, any government monetary policy will be substantially offset if the liabilities of financial intermediaries are close substitutes for money. The second reason has to do with the appropriate definition of "money" and asks if a simple-sum aggregate such as M2 is a good measure of the money stock and is an appropriate monetary target [2; 3; 6; 10; 15].

   The most common procedure to measure the degree of substitutability is the estimation of interest cross-elasticity from a demand function for currency and demand deposits [12; 13; 18]. The demand function typically includes the rates of return on one of more near-money assets, plus an income or wealth measure as an explanatory variable. Theory and empirical estimates, however, provide little guidance about the magnitude of cross-elasticity that constitutes a "close" substitutability.(2) The interest cross-elasticity approach therefore fails to bridge the gap between empirical estimates and policy issues.

   This paper follows the approach, first proposed by Chetty and later extended by Barnett, of estimating the degree of asset substitutability by direct estimation of the parameters of a utility function. Following Barnett, our model specifically recognizes the consumer's inter-temporal choice implicit in the choice between consumption and holding assets. We consider an infinitely lived consumer who derives utility from consumer goods and the services provided by real money holdings. Including the equity holdings in the unregulated financial market in the consumer budget constraint, we account explicitly for the existence of dual markets. Moreover, the model allows for the possibility that a consumer's liquidity service may vary with economic growth. We assume that the shares of assets in the consumer's portfolio are time-dependent and are functions of income. Estimates of the parameters of this model are used to construct a measure of a monetary aggregate which is consistent with the individual's utility maximization. The remainder of this paper is divided into three sections. In section II, a general theoretical model is presented. Section III describes data and presents the empirical results. Section IV presents a comparison of various measures of monetary aggregates. A brief conclusion is given in section V.

2. The Model

   Consider the decision problem of an infinitely lived consumer who derives utility from both consumption and the liquidity service provided by holding various assets. Denote the consumption and liquidity service at time t by [C.sub.t] and [L.sub.t].

   The consumer is assumed to maximize the discounted utility.(3) (1) [Mathematical Expression Omitted] where [Rho] is the subjective discount rate and U(.) is the concave utility function, and U(.) is monotonically increasing in both [C.sub.t] and [L.sub.t].

   Since our interest is in the estimation of liquidity service [L.sub.t], it is necessary to specify how liquidity service is related to asset holding. The measure of liquidity service is assumed to be a constant elasticity of substitution (CES) function of real money holing, [M.sub.t]/[P.sub.t] and real savings and time deposits, [S.sub.t]/[P.sub.t], where [P.sub.t] is a price index, (2) [Mathematical Expression Omitted] The coefficient [Lambda] determines the elasticity of substitution between real money holding and real savings and time deposits, and is given by 1/(1 - [Lambda]). The distribution coefficient [[Delta].sub.t] is assumed to be time-dependent. When [[Delta].sub.t] = 1/2 and [Lambda] = 1, the real money holding and real savings and time deposits are identical with respect to liquidity service. In this case, money and interest bearing deposits are perfect substitutes, and the liquidity measure L is equivalent to the simple-sum monetary aggregate, (M + S)/P.

   The consumer budget constraint at time i is (3) [Mathematical Expression Omitted] where [N.sub.i] is the equity holdings in the unregulated market and serves as the numeraire asset.(4) [Y.sub.i] is real income from non-asset service, [r.sub.i] is the nominal rate of return on holding equity, and [d.sub.i] is the nominal rate of return on savings and time deposits.

   Following Barnett [2], the budget constraints (3) can be solved for the equity holding for the period i = t + T. By repeatedly backward substituting the equity holding [N.sub.j] for the period j [is less than or equal to] t + T down to period t, the multi-period constraints can be expressed as a single constraints, (4) [Mathematical Expression Omitted] where [[Eta].sub.i] = 1, for i = t

   = (1 + [r.sub.t])(1 + [r.sub.t+1])...(1 + [r.sub.t-1]), for t + 1 [is less than or equal to] i [is less than or equal to] t + T. The...