The purpose of this study was to revise and supplement the ‘KERI-1997’ macroeconomic model in order to reflect changes in the internal and external environments of the Korean economy, particularly since in the foreign exchange crisis in 1997. The new model ‘KERI-2005’ created from this study is to be utilized in the future quarterly economic projections and policy analyses.

The characteristics of the revised macroeconomic model are, first, it enables us to identify the way that taxation policy - income tax, corporate tax, tax exemptions on investments, etc. - spreads through the real economy and financial sectors via private consumption, investment, etc. and also to estimate its effects. Second, it enables us to predict the impact of government expenditure on the private sector differentially in terms of current expenditure and capital expenditure. Third, it makes it possible to analyze effects of monetary policy changes in terms of call interest rate rather than monetary aggregates on the real economy and the financial sector, reflecting the 1998 change in the Bank of Korea’s monetary policy procedure. Fourth, the external sector has a more rich specification. Especially by including the Chinese economy, which has emerged as the largest trading partner for Korea, we can gauge the impact of changes in China’s economic growth or yuan currency exchange rates on Korea.

Some important policy implications obtained in the course of developing this model and policy simulation are as follows. First, lowering corporate tax rates is an effective countermeasure to the recent sharp investment slowdown. Policy simulations show that 1 percentage point cut in the tax rate would increase real GDP by up to 0.36% through facility expansion. Second, in the case of fiscal expenditure, the effect of capital expenditure appeared far greater than that of current expenditure. To enhance the efficiency of fiscal expenditure, therefore, the expenditure must be focused intensively on R&D or SOC investment, which are conducive to expansion of the growth potential, rather than on temporary pump-priming. Third, simulations show that a 0.25 percentage point cut in call interest rate increases real GDP by about 0.08～0.12% and consumer prices by 0.01～0.08%. This suggests that the BOK needs to be cautious in raising the short-term policy rate hike in the current situation where economic recovery is uncertain. Finally, the Chinese yuan’s appreciation appears to be disadvantageous to Korea's exports on the whole.

Like many, our model is a somewhat fragile caricature of the complex economic system. Further improvements are in order in terms of estimation methodology (least squares) and the conceptual framework that is subject to the Lucas critique. We plan to make frequent revisions and upgrades. Also, results of policy analyses will be carefully interpreted.