Linkage between US monetary policy and emerging economies: the case of Korea’s financial market and monetary policy

Abstract

This study offers empirical evidence on the linkage between the US monetary policy and Korean financial market volatilities, and the efficacy of Korea?s? monetary policy in the past decade and a half. First, we find evidence showing significant effects of interest spreads between short and long term interest rates of Korea and the US, and other US variables on the volatility of won-dollar exchange rate as well as Korean stock market index. Second, we find evidence that suggests that capital inflow into Korea might have weakened the efficacy of its monetary policy since the mid-2000s, a period notable for the increased accession by foreign investors to the Korean bond market and the US quantitative easing (QE) policy. A distinct change in the propagation mechanism of monetary policy, in which short term policy rate affects long term interest rates, is observed in Korea since the mid-2000s. In the latter sample period, US monetary policy appears to have had more influence on Korean market interest rates than Korea?s policy rate. In addition, we examine structural issues of the balance sheet of Korea?s? central bank in view of recent rise in interests in the financial health of central bank balance sheets and monetary policy credibility in the wake of QE policies in advanced economies.