The Effect of Financial Market Integration on Monetary Policy and Long-Term Interest Rate in Korea and Its Policy Implications

Abstract

Financial market integration mitigates production shocks that occur in a country by pooling the risk through portfolio diversification and this contributes to consumption smoothing for life-time utility maximization. Financial market integration also contributes to economic growth by supplying capital to developing countries via the integrated financial market. However, the integrated financial market also serves as a transition channel where the financial shock which originated from the center country spreads to its neighboring economies. In the event of a financial crisis, there is a potential risk of capital flight from neighboring countries to the financial center, meaning that many countries in the integrated financial market have an economic structure that is vulnerable to external shocks. As the uncertainties in the international financial market increased significantly during the financial crisis, financial variables such as asset prices, leverage, credit growth, and capital flows in many countries were heavily affected by global financial market sentiments rather than their own monetary policies. This is evidence supporting that many countries in the global financial market have constrained monetary policies. In this report, we try to understand how monetary policy is constrained in the context of the international financial market, from which we can derive relevant policy implications. To this end we analyze how monetary policies are restricted by introducing the concept of monetary policy independence.