Effects of Monetary Policy Shocks on the - Recherche en IA spécialisée au MIT

Effects of Monetary Policy Shocks on the
Exchange Rate in the Republic of Korea:
Capital Flows in Stock and Bond Markets
SOYOUNG KIM

∗

Several studies have suggested that the prediction of standard theory on the ef-
fects of monetary policy on the exchange rate might not be applicable to or in the
case of the Republic of Korea because participation of foreign investors is weak
in the bond market but strong in the stock market. The current study examines
the effects of monetary policy shocks on the exchange rate in the Republic of
Korea by using structural vector autoregression models with sign restrictions.
To determine the channels by which monetary policy shocks affect the exchange
rate, I investigate the effects on various components of capital ﬂows. The main
empirical ﬁndings are as follows. D'abord, a contractionary monetary policy shock,
which increases the interest rate, appreciates the Korean won signiﬁcantly in
the short run as predicted by most theories. Deuxième, contractionary monetary
policy shocks increase capital inﬂows into the bond market consistent with the
prediction of the uncovered interest parity condition. This seems to be the main
channel by which contractionary monetary shocks appreciate the won. Enfin,
foreign investors tend to withdraw money from the domestic stock market in
response to a monetary tightening, resulting in a decrease in capital inﬂows.

Mots clés: monetary policy shocks, vector autoregression, sign restrictions,
exchange rate, capital ﬂows
Codes JEL: F31, F32, F33, F36

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je. Introduction

Since the 1990s, many emerging Asian economies have liberalized capital
accounts and opened ﬁnancial markets to foreign investors. Foreign investors to
date own a huge amount of stocks in emerging markets. Ainsi, international capital
ﬂows into domestic stock markets have become important sources of exchange
rate instability as evidenced by the recent global ﬁnancial crisis. Cependant, foreign
ownership in some emerging Asian bond markets, Par exemple, the Republic of
Korea, is still negligible.

∗Professor, Department of Economics, Seoul National University. I thank Peter Morgan, Changyong Rhee, Masahiro
Kawai, Maria Socorro Bautista, Jae-Ha Park, Charles Horioka, and the seminar participants at the Asian Development
Review conference for their useful comments and suggestions. Financial support from the Institute of Economic
Research of Seoul National University is gratefully acknowledged.

Revue du développement en Asie, vol. 31, Non. 1, pp. 121–135

C(cid:3) 2014 Banque asiatique de développement
et Institut de la Banque asiatique de développement

122 ASIAN DEVELOPMENT REVIEW

In advanced countries, foreign investors actively participate in bond markets.
In some countries, they even participate in bond markets more actively than they do
in stock markets. Par exemple, a huge amount of United States (NOUS) debt securities
(par exemple., Treasury bills) is owned by foreigners. In contrast, foreign investor ownership
is limited in the US stock market. Such a difference in foreign investor participation
in stock and bond markets may generate an important difference in the transmission
of structural shocks in emerging and advanced countries. The current study investi-
gates one interesting aspect of structural shock transmission, c'est, the effects of
monetary policy shocks on the exchange rate of an emerging Asian country.

Most international monetary and macro models predict that a contractionary
monetary policy shock, which increases the interest rate, leads to domestic currency
appreciation, other things being equal. Traditional Mundell–Fleming–Dornbusch
models and recent New Open Economy macroeconomic models incorporate a ver-
sion of the interest parity condition. This implies that, other things being equal,
an increase in the domestic interest rate leads to domestic currency appreciation
because the expected return on domestic bonds (denominated in domestic currency)
becomes relatively higher than the expected return on foreign bonds (denominated
in foreign currency). Donc, the relative demand between domestic and foreign
currency increases net capital inﬂows into the domestic bond market and appreciates
the domestic currency against the foreign currency.

A number of studies have empirically tested such a standard prediction for
advanced countries (Eichenbaum and Evans 1995, Kim and Roubini 2000, Kim
2003, Faust and Rogers 2003, Kim 2005, Scholl and Uhlig 2009). These studies
found that a contractionary monetary policy shock leads to domestic currency ap-
preciation, a ﬁnding consistent with standard theory, although the shape of exchange
rate responses does not perfectly match the standard theoretical predictions implied
by the uncovered interest parity condition.

Cependant, if the domestic bond market is not fully developed and foreign
investors do not actively participate in the domestic bond market of emerging coun-
tries, the standard channel through the domestic bond market may not function well.
An increase in the domestic interest rate may also lead to a depreciation of the
domestic currency through the stock market channel. Foreign investors may with-
draw money from the domestic stock market as contractionary monetary shocks
have adverse effects on the domestic economy. Capital outﬂows in the stock market
may lead to exchange rate depreciation. Several studies (Kim and Ryou 2001, Lee
and Ryou 2006) examined a reduced form or a simple timing relation between the
interest rate and the exchange rate in the Republic of Korea. The results suggest that
a rise in the interest rate corresponds to Korean won depreciation or that interest
rate appreciation does not signiﬁcantly affect the exchange rate.1

1Several studies (Radelet and Sachs 1998; Stiglitz 1999; Wade 1998; Dekle, Hsiao, and Wang 2002; Ohno,
Shirono, and Sisli 1999) suggested that a high interest rate policy increases the interest burden of highly leveraged

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MONETARY POLICY SHOCKS ON THE EXCHANGE RATE IN THE REPUBLIC OF KOREA 123

To clarify this issue, this study examines the effects of monetary policy
shocks on the exchange rate in the Republic of Korea. Although previous studies
have examined the reduced form or simple timing relation between the interest rate
and exchange rate, a reduced from or a simple timing relation between the interest
rate and exchange rate can be generated from structural shocks other than monetary
policy shocks. The current study employs a structural vector autoregression (VAR)
model with sign restrictions developed by Uhlig (2005) to identify exogenous shocks
on monetary policy and examine the effects of identiﬁed shocks on the exchange
rate. This study also examines the effects of monetary policy shocks on various
components of capital ﬂows, such as capital inﬂows (liabilities) and outﬂows (assets)
in stock and bond markets, to determine the mechanism by which monetary policy
shocks affect the exchange rate.2

The rest of the paper is organized as follows. Section II explains the em-
pirical methodology. Section III provides the empirical results on the effects of
monetary policy shocks on exchange rate. Section IV discusses the detailed trans-
mission mechanism by examining the effects of monetary policy shocks on various
components of capital ﬂows. Section V concludes and presents a summary.

II. Empirical Method and Data

UN.

Structural Vector Autoregression Models with Sign Restrictions

To identify exogenous monetary policy shocks and examine the effects of
the identiﬁed shocks on the exchange rate, structural vector autoregression (VAR)
models with sign restrictions (Uhlig 2005) are used. Past studies on the effects of
monetary policy have frequently used structural VAR models, which are effective in
identifying exogenous monetary policy shocks. By imposing proper sign restrictions,
several puzzling responses (par exemple., liquidity and price puzzles) can be eliminated.3
Given that puzzling responses are often regarded as failures in identifying proper
monetary policy shocks, the identiﬁcation strategy with sign restrictions is appealing.
The methodology of the structural VAR model with sign restrictions is brieﬂy
décrit ci-dessous.

ﬁrms and raises bankruptcy rates, thus worsening the economic environment and bringing about further depreciation
during a ﬁnancial crisis.

2See Kim (2013b) for more general results on emerging countries.
3An exogenous monetary expansion (contraction) is supposed to increase (decrease) monetary aggregates
and price levels and decrease (increase) interest rates. Cependant, in a model that uses innovations in broad monetary
aggregates as monetary policy shocks, both monetary aggregates and interest rates increase. This phenomenon is
called the “liquidity puzzle.” On the other hand, in a model that uses innovations in interest rates as monetary policy
shocks, both interest rates and price levels increase. This phenomenon is called the “price puzzle.” These puzzles are
often regarded as indications that exogenous shocks to monetary policy are not properly identiﬁed in the model (Kim
2013un).

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124 ASIAN DEVELOPMENT REVIEW

A reduced form of the VAR model is considered:

Yt = B(L)Yt−1 + C (L) X t + ut

(1)

where Yt is an l × 1 vector of endogenous variables, X t is an m × 1 vector of
exogenous variables, ut is a l × 1 residual vector, E(ut ) = 0, E(ut u(cid:4)
t ) = (cid:2), et
B(L) and C(L) are l × l and l × m matrix polynomials in lag operator L.

In previous studies, reduced-form residuals and elements of ut are the linear

combinations of structural shocks:

ut = Avt

(2)

where A is an l × l matrix, vt is an l × 1 vector of structural shocks, E(vt ) = 0, et
E(vt v(cid:4)
t ) = 1. Previous studies often recovered orthogonal structural shocks from
reduced-form residuals by determining A. Par exemple, the recursive identiﬁcation
strategy developed by Sims (1980) recovers A as a lower triangular matrix by
applying Cholesky decomposition on (cid:2).

Uhlig (2005) has identiﬁed structural shocks by imposing sign restrictions on
impulse responses. The study has identiﬁed only one structural shock in particular,
c'est, monetary policy shocks, which amounts to identifying a single column
a ∈ Rm of the matrix A. Uhlig (2005) deﬁnes the impulse vector as follows.

Deﬁnition 1. The vector a ∈ Rm is called an impulse vector if matrix A exists;

thus, A A(cid:4) = (cid:2) and a is a column of A.

Uhlig (2005) shows that any impulse vector a can be characterized by a = ˜Aα, où
˜A ˜A(cid:4) = (cid:2) is a Cholesky decomposition of (cid:2), and α is an l-dimensional vector of
unit length. Thereafter, the vector impulse response ra(k) for a is expressed by the
following: ra(k) =
α jr j (k), where r j (k) ∈ Rl is the vector response at horizon
k to the jth shock in a Cholesky decomposition of (cid:2). A list of inequality restrictions
on the entries of the vector impulse response ra(k) at various horizons k is then
imposed.

(cid:2)
je
j=1

Following the pure sign restriction approach by Uhlig (2005), a Bayesian prior
for the VAR parameters (B, (cid:2)) and an independent uniform prior for α are assumed.
Only the draws that satisfy the inequality restrictions are retained in the simulation
exercise. The probability bands are calculated based on 10,000 such draws.

Empirical Model and Data

The estimation period is relatively short. Ainsi, only ﬁve endogenous vari-
ables are included in the baseline VAR model: the call rate (CR), the monetary
base (MB), the consumer price index (CPI), industrial production (IP), et le

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MONETARY POLICY SHOCKS ON THE EXCHANGE RATE IN THE REPUBLIC OF KOREA 125

won–dollar exchange rate (ERA). The ﬁrst four variables are key macro/monetary
variables. These are included to identify monetary policy shocks. The last variable
is the focus of this study.

Two variables are also included as exogenous variables in the baseline model:
the federal funds rate (FFR) and a variable representing worldwide risk conditions.
The FFR is included to control for US monetary policy, which is likely to affect the
exchange rate. A variable representing worldwide risk conditions is included because
it is also likely to affect the won–dollar exchange rate and capital inﬂows into and
outﬂows from the Republic of Korea. Given that assets in emerging countries like the
Republic of Korea are riskier than assets in the US, changes in worldwide risks are
likely to affect the relative price of assets in emerging versus advanced countries (ou
the risk premium of the won relative to the dollar) and consequently capital ﬂows
and exchange rates. Par exemple, an increase in uncertainty or credit risk in the
world economy may prompt international investors to purchase assets in advanced
des pays, which are relatively safer, by selling assets in emerging countries, lequel
are relatively riskier.

The FFR and worldwide risk conditions are assumed to be exogenous to do-
mestic variables because the variables of a small open economy such as the Republic
of Korea are not likely to affect US or worldwide variables. These exogenous vari-
ables are also not restricted in terms of their contemporaneous effect on endogenous
variables in the model (Équation (1)).

The following sign restrictions on impulse responses are imposed to identify
contractionary monetary policy shocks: (1) increased call rate, (2) decreased mone-
tary base, et (3) decreased CPI. By imposing these restrictions, liquidity and price
puzzles are avoided. Ainsi, the impulse responses of these basic macro variables to
monetary policy shocks are consistent with conventional wisdom on the effects of
monetary policy. The sign restrictions are imposed on the impulse responses for the
ﬁrst 12 months after a shock.4

Thereafter, various components of ﬁnancial accounts (capital ﬂows) are added
one by one to infer the transmission mechanism in the baseline model. Given that
the sign restrictions imposed in the baseline model can identify monetary policy
shocks, no additional restrictions are imposed in the extended models.

Monthly data are used. A constant term and six lags are assumed. The estima-
tion period is from January 1999 to June 2012. The sample starts from 1999 because
monetary policy operating procedures in the Republic of Korea have changed sub-
stantially, with the capital account almost fully liberalized after the Asian ﬁnancial
crise (Kim and Park 2006, Kim and Yang 2012). The CBOE DJIA Volatility Index
(VIX) is used as the variable to represent worldwide risk. The difference between

4Following Scholl and Uhlig (2009), the restrictions are imposed for 12 mois. The main results are still
qualitatively similar even when the restrictions are imposed under different durations. Several results are reported in
Section IV.C.

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126 ASIAN DEVELOPMENT REVIEW

Tableau 1. Participation Rate of Foreign Investors in Bond and Stock Markets in the
Republic of Korea

2001
0.09
32.80

2002
0.11
36.30

2003
0.29
41.20

2004
0.48
40.50

2005
0.46
37.20

2006
0.59
35.10

2007
4.45
32.70

2008
4.33
27.20

2009
5.57
30.50

2010
6.64
31.20

2011
6.90
30.60

Bonds
Stocks

Sources: Bank of Korea, Financial Supervisory Service, Korea Exchange.

the US Baa corporate bond yield (Moody’s seasoned Baa corporate bond yield) et
the 10-year US Treasury constant maturity rate, representing credit risks, is also
used in the extended experiment. Korean data are obtained from the web page of
the Bank of Korea. US data are obtained from the Macro Database of the Federal
Reserve Bank of St. Louis.

Tableau 1 shows the participation rate of foreign investors in the stock and bond
markets of the Republic of Korea in 2000. Foreign investors owned a substantial
fraction of stocks (ranging from 27% à 42%) but only a small fraction of bonds
(less than 10%). Before 2007, foreign investors owned less than 1% of bonds.

III. Empirical Results: Effects on Exchange Rate

UN.

Baseline Model

Chiffre 1 shows the impulse responses of the macro variables to monetary pol-
icy shocks in the baseline model with 68% probability bands for a 4-year horizon.5
The name of each variable is denoted at the top of each graph. By imposing the sign
restrictions, the price and liquidity puzzles are avoided. In response to monetary
policy shocks, the interest rate increases and the monetary base and price level de-
crease. These are likely responses under exogenous monetary contraction. Industrial
production declines over time; the peak response is found to occur approximately
15 months to 20 months after the shock.

The domestic currency appreciates on impact and then depreciates back to
the initial level approximately 20 months after the shock. The probability bands do
not include the zero response in the short run. The standard theory suggests that,
other things being equal, an exogenous monetary contraction, which increases the
interest rate, will appreciate the domestic currency in the short-run. The empirical
result matches the prediction.6

I then examine the nature and the size of monetary shocks and exchange rate
responses more carefully. The interest rate increases by 0.04 percentage point on

5The number of estimated parameters is relatively large compared to the data point, hence a 68% probability

band (or one-standard error band) is used for inference.

6The domestic currency depreciates back to the initial level in the long run. The long run effect is therefore
close to zero. This ﬁnding is puzzling because the monetary base and price levels decline in the long run. A brief
explanation is provided in Section IV.

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MONETARY POLICY SHOCKS ON THE EXCHANGE RATE IN THE REPUBLIC OF KOREA 127

Chiffre 1. Impulse Responses to Monetary Policy Shocks—Baseline Model

0.08

0.04

0.00

–0.04

–0.20

–0.40

–0.60

–0.80

–0.00

–0.10

–0.20

–0.30

CPI

0.40

–0.00

–0.40

–0.80

0.25

–0.25

–0.75

–1.25

ERA

CPI = consumer price index, CR = call rate, ERA = won–dollar exchange rate, IP = industrial production,

MB = monetary base.

Note: This ﬁgure shows the impulse responses to monetary policy shocks for a 4-year horizon in the baseline model.
The solid line is the median response, while dotted lines are 68% probability bands. The name of each responding
variable is denoted at the top of each graph.

Source: Author’s computations.

impact and stays 0.04–0.06 percentage point above the initial level for one year. Le
interest rate decreases back to the initial level in 20 months or so. In response to
such monetary policy shocks, the exchange rate appreciates about 0.75% on impact,
which is the maximum effect. The domestic currency depreciates back to the initial
level in about 20 months or so.

Extended Experiments

To check the robustness of the results, several alternative speciﬁcations are
investigated. D'abord, industrial production and CPI of the US are added one by one
as exogenous variables in the model (“CPI_US added” and “IP_US added” in
Chiffre 2). Basic economic conditions in the US such as economic activity and
the price level (represented by industrial production and CPI) may be important
to explain exchange rate movements. Deuxième, the difference between the US Baa
corporate bond yield and the 10-year US Treasury constant maturity rate, lequel
proxies for credit risk, is used instead of VIX (“VIX” in Figure 2).7 Troisième, le
duration of the sign restrictions is changed to 6 et 18 months instead of 12 mois
(“6 months” and “18 months” in Figure 2). Fourth, M2 is added as an additional
endogenous variable to check whether a broad monetary aggregate decreases in
response to identiﬁed monetary policy shocks as expected in an actual exogenous
monetary contraction (“M2_added” in Figure 2). Enfin, foreign exchange reserves

7The correlation between the two variables for the sample period is 0.8.

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128 ASIAN DEVELOPMENT REVIEW

Chiffre 2. Impulse Responses to Monetary Policy Shocks—Extended Models

–1

–2

0.5

0.0

–0.5

–1.0

–1.5

0.5

0.0

–0.5

–1.0

–1.5

IPUS_added, ERA

CPIUS_added, ERA

Alternative Risk, ERA

–1

–2

0.5

0.0

–0.5

–1.0

–1.5

0.5

0.0

–0.5

–1.0

–1.5

6 mois, ERA

18 mois, ERA

M2 added, ERA

0.5

0.0

–0.5

–1.0

–1.5

0.5

0.0

–0.5

–1.0

1.0

0.5

0.0

–0.5

–1.0

FR added, ERA

M2 added, M2

M2 added, ERA

6 months = sign restrictions imposed for 6 mois, 18 months = sign restrictions imposed for 18 mois, Alternative
Risk = the difference between the US Baa corporate bond yield and the 10-year US Treasury constant maturity
rate used instead of VIX, CPIUS_added = US consumer price index added to model, ERA = won–dollar
exchange rate, FR = foreign exchange reserves, FR_added = foreign exchange reserves added to model,
IPUS_added = US industrial production added to model, M2 = broad money measure, M2_added = broad
money measure added to model.

Note: This ﬁgure shows the impulse responses to monetary policy shocks for a 3-year horizon in the extended model.
The solid line is the median response, while dotted lines are 68% probability bands. The name of each model
and each responding variable is denoted at the top of each graph.

Source: Author’s computations.

(FR) is added as an additional endogenous variable to infer the foreign exchange
intervention (“FR_added” in Figure 2).

The results are reported in Figure 2. The results of all models are not too
different from those of the baseline model. The domestic currency appreciation is
found as predicted by the standard theory predicts. The domestic currency appreci-
ates on impact and then depreciates to the initial level over time. The error bands
do not include zero responses in the short run. In the model where M2 is added, M2
decreases over time in response to a contractionary monetary policy shock. Tel
responses of M2 are expected in exogenous monetary contraction, a result that fur-
ther supports the validity of the empirical model. Enfin, foreign exchange reserves
do not change signiﬁcantly, which may imply that foreign exchange intervention is
not clearly found after monetary policy shocks. This suggests that we do not need
to pay too much attention to foreign exchange intervention when we examine the
effects of Korean monetary policy shocks on exchange rate.

IV. Detailed Transmission Mechanism: Effects on Components of Capital Flows

UN.

Theory

To explore further the detailed channels through which monetary policy
shocks affect the exchange rate, I examine the effects of these shocks on the various

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MONETARY POLICY SHOCKS ON THE EXCHANGE RATE IN THE REPUBLIC OF KOREA 129

components of capital ﬂows. Theoretically, an exogenous monetary contraction that
increases domestic interest rate affects the portfolio choice of foreign and domestic
investors in the following ways. D'abord, domestic bonds become more attractive be-
cause they offer higher interest rates. Deuxième, domestic stocks become less attractive
because monetary contraction is likely to have an adverse effect on the domestic
economy and a substitution from domestic stocks to domestic bonds may transpire
considering that domestic bonds offer better returns. Troisième, given that foreign bonds
offer relatively less returns than domestic bonds, the former becomes less attractive.
Fourth, the sale of domestic stocks (with a negative expectation on the domestic
economy after monetary contraction) may lead to the purchase of foreign bonds.
Fifth, foreign stocks become less attractive because a substitution from foreign
stocks to domestic bonds may occur. Sixth, the sale of domestic stocks may lead to
the purchase of foreign stocks.

These changes in portfolio choices are likely to affect various components
of capital ﬂows and exchange rates. D'abord, foreign investors are likely to purchase
domestic bonds because they offer higher returns, thus resulting in an increase in cap-
ital inﬂows for the bond market and appreciation of the domestic currency. Deuxième,
foreign investors are likely to sell domestic stocks because they become less attrac-
tive under a negative perspective on the domestic economy after monetary contrac-
tion. This condition is likely to result in a decrease in net capital inﬂow in the stock
market and the depreciation of the domestic currency. Troisième, domestic investors are
likely to sell foreign bonds to purchase domestic bonds, thus leading to a decrease in
net capital outﬂow for the bond market and domestic currency appreciation. Fourth,
domestic investors may purchase foreign bonds if they wish to substitute domestic
stocks with foreign bonds, thus leading to an increase in net capital outﬂow for the
bond market and depreciation of the domestic currency. Fifth, domestic investors
may sell foreign stocks to purchase domestic bonds that offer higher returns, thus
resulting in a decrease in net capital outﬂow for the stock market and appreciation
of the domestic currency. Sixth, domestic investors may purchase foreign stocks if
they would like to substitute domestic stocks with foreign stocks, thus leading to
an increase in net capital outﬂow for stock market and depreciation of the domestic
currency.8

The standard theory, which is based on a relation like the interest parity
condition, suggests that the ﬁrst and the third channels should work for domestic
and foreign bond markets. De plus, the domestic currency appreciates through
the ﬁrst, troisième, and ﬁfth channels but depreciates through the second, fourth, et
sixth channels. If foreign investors do not actively participate in the domestic bond
marché, the ﬁrst channel may not work. If domestic investors are restricted from

8Foreign investors’ buying and selling strategy may have an impact on domestic investor sentiment, lequel
may amplify the effects of foreign investors’ actions. On the other hand, domestic currency appreciation following
monetary contraction worsens the trade balance and decreases output, which may make the negative effect on stock
price stronger.

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130 ASIAN DEVELOPMENT REVIEW

Tableau 2. Basic Properties of the Components of Capital Flows

Bond, Asset (Net Outﬂows)
Bond, Liability (Net Inﬂows)
Stock, Asset (Net Outﬂows)
Stock, Liability (Net Inﬂows)
Loan, Asset (Net Outﬂows)
Loan, Liability (Net Inﬂows)

Mean
0.35
1.43
0.62
0.68
0.23
−0.06

Standard Deviation
1.57
3.16
1.80
3.37
2.80
5.50

Note: This table shows the mean and standard deviation of various types of capital ﬂows (monthly frequency). Chaque

variable is expressed as a percent of trend gross domestic product.

Sources: Bank of Korea

investing in foreign bond and stock markets, the last four channels may not work. If
only the second channel works, then the domestic currency depreciates.

Empirical Results: Baseline Model

To explore whether each channel works, the effects of monetary policy shocks
on various components of capital ﬂows are examined by extending the baseline
model (Section II.B). Capital ﬂows are divided into two large categories: net capital
inﬂows (net changes in liability ﬂows) and net capital outﬂows (net changes in
asset ﬂows). Three types of net capital inﬂows and outﬂows are considered, namely,
stocks, bonds, and loans. Although theoretical predictions on capital ﬂows in loan
markets are not discussed in Section IV.A, capital ﬂows in loan markets are examined
empirically because capital ﬂows in loan and bond markets are likely to behave
similarly in theory.

Each variable is stated in US dollar terms, divided by trend US dollar GDP
for normalization, and then multiplied by 100. Donc, each variable is expressed
as a percentage of trend GDP.9 Table 2 shows the mean and standard deviation of
each component. For each component, net inﬂows (liability) are more volatile than
net outﬂows. The volatilities of stock and bond ﬂows do not differ much, mais le
volatility of loan ﬂows exceed the volatility of stock and bond ﬂows.

Chiffre 3 shows the (cumulative) impulse responses of various components of
capital ﬂows for a 2-year horizon. Cumulative responses are reported to infer whether
capital ﬂows increase up to a certain time horizon after the shock. The graphs in
the ﬁrst and the second columns show the components of net capital outﬂows and
inﬂows, respectivement. The graphs in the ﬁrst, second, and third rows show the capital
ﬂows in bonds, stocks, and loan markets, respectivement. To aid comparison of the
sizes of inﬂows and outﬂows for each market, scales of the graphs in the same row
are identical by construction.

9A linear trend is used, but the results are similar when other trend types (par exemple., a quadratic trend, the trend
obtained using the HP ﬁlter) are used. GDP is calculated in monthly terms to be consistent with monthly capital ﬂows.

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MONETARY POLICY SHOCKS ON THE EXCHANGE RATE IN THE REPUBLIC OF KOREA 131

Chiffre 3. Impulse Responses of Components of Capital Flows—Baseline Model

–1

–2

–4

–6

–2

Bond

Stock

Loan

Asset (net outflows)

–1

–2

–4

–6

–2

Liability (net inflows)

Note: This ﬁgure shows the (cumulative) impulse responses of various components of capital ﬂows to monetary
policy shocks for a 2-year horizon. The solid line is the median response while dotted lines are 68% probability
bands. The graphs in the ﬁrst and the second columns show the components of net capital outﬂows and inﬂows,
respectivement. The graphs in the ﬁrst, second, and third rows show the capital ﬂows in bonds, stocks, and loan
marchés, respectivement.
Source: Author’s computations.

D'abord, capital inﬂows decrease sharply for the stock market in response to a
contractionary monetary policy shock. The probability bands do not include zero
réponses. This ﬁnding implies that the second channel works strongly; c'est,
foreign investors withdraw money from the domestic stock market after domestic
monetary tightening. Cependant, capital outﬂows for the stock market do not change
signiﬁcantly.

Deuxième, capital inﬂows for the bond market increase, a result consistent with
the ﬁrst channel. The short-run response is also signiﬁcant. Coinciding with the
prediction of standard theory, foreign investors purchase domestic bonds because of
better returns. Capital inﬂows for the loan market also increase, although probability
bands include the zero response.

Troisième, capital outﬂows for the bond market also increase signiﬁcantly consis-
tent with the fourth channel. This result suggests that domestic investors purchase
foreign bonds after selling domestic stocks. In contrast, capital outﬂows for the loan
market do not change signiﬁcantly. Also note that the increase in capital inﬂows for
bond and loan markets exceed that of capital outﬂows, indicating net capital inﬂows.
The standard bond market channel is therefore functional. Some of the past
studies have questioned this channel because of the relatively weak participation of
foreign investors in the Korean bond market. Cependant, the empirical results show
that foreigners invest more in domestic bonds after domestic monetary contraction.10

10The signiﬁcant effect through the bond market may be related to the rising trend of foreign participation in
the bond market from 0.48% dans 2004 à 6.9% dans 2011, as shown in Table 1. The increase in foreign participation may

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132 ASIAN DEVELOPMENT REVIEW

On the contrary, the other side of the standard bond market channel does not seem
to work well. Empirical results show that domestic investors purchase foreign bonds
after a domestic monetary contraction. Domestic investors may end up purchasing
foreign bonds after selling domestic stocks with negative prospects after monetary
contraction. Cependant, the increase in capital inﬂows for the bond market seems to
be larger than that of capital outﬂows in the short run. En outre, capital inﬂows for
the loan market increase (although not signiﬁcantly), whereas capital outﬂows do
not change substantially. These results suggest that capital ﬂows in bond and loan
markets lead to domestic currency appreciation in the short run.

Enfin, similar to the claim of some past studies, foreign investors sell domes-
tic stocks after monetary contraction. This ﬁnding is probably due to the negative
perspective on the domestic economy after monetary contraction. This condition
may lead to domestic currency depreciation, as suggested by previous studies. Comment-
jamais, the increase in capital inﬂows for bond and loan markets is relatively stronger
than the decrease in capital inﬂows for the stock market. Dans l'ensemble, the empirical result
shows that the domestic currency appreciates.11

Extended Experiments

To check the robustness of the results even further, effects of monetary policy
shocks on the components of capital ﬂows are examined based on the alternative
models discussed in Section III.C. Similar to the baseline model, each component
of capital ﬂows is added to each alternative model without imposing any further
restrictions. The results are reported in Figure 4. Each column of ﬁgures shows
the results from each model, and each row of ﬁgures shows the results for each
component of capital ﬂows. To facilitate the comparison, the graphs in the ﬁrst two,
next two, and last two rows have the same scale.

D'abord, the short-term increase in capital inﬂows for the bond market is signiﬁ-
cant in all models. Capital outﬂows for the bond market also increase signiﬁcantly;
cependant, the increase in outﬂows tends to be smaller than the rise in inﬂows, partic-
ularly in the short run. These empirical ﬁndings on capital ﬂows in the bond market
are robust across different models.

Capital outﬂows for the stock market tend to decrease in all models. Cependant,
the decrease is not signiﬁcant in some models. Changes in capital inﬂows for the
stock market are relatively small compared with the changes in capital outﬂows.
Capital inﬂows for the loan market increase in most models, signiﬁcantly so in some

be related to various regional efforts on developing bond markets (par exemple., the Asian Bond Market Initiative and Asian
Bond Funds). Refer to Kim and Yang (2011) for Asian ﬁnancial cooperation.

11Note that the decrease in capital inﬂows to the stock market and the increase in capital outﬂows to the bond
market are more persistent than the increase in capital inﬂows to bond and loan markets. This may explain why the
domestic currency does not appreciate in the long term despite the long-term decrease in price levels and monetary
base.

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MONETARY POLICY SHOCKS ON THE EXCHANGE RATE IN THE REPUBLIC OF KOREA 133

Chiffre 4. Impulse Responses of the Components of Capital Flows—Extended Experiments

6 months = sign restrictions imposed for 6 mois, Alternative Risk = the difference between the US Baa corporate
bond yield and the 10-year US Treasury constant maturity rate used instead of VIX, CPIUS_added = US
consumer price index added to model, IPUS_added = US industrial production added to model, M2_added =
broad money measure added to model.

Note: This ﬁgure shows the (cumulative) impulse responses of various components of capital ﬂows to monetary
policy shocks for a 2-year horizon in the extended models. The solid line is the median response while dotted
lines are 68% probability bands. Each column of ﬁgures shows the results from each model, and each row of
ﬁgures shows the results for each component of capital ﬂows.

Source: Author’s computations.

models. Capital outﬂows for the loan market also increase in some cases. Cependant,
the rise is insigniﬁcant and relatively small in most cases. To summarize, similar
to the baseline model, capital inﬂows to the loan market tend to increase, alors que
capital inﬂows for the stock market tend to decrease. Nevertheless, these results are
not signiﬁcant in some cases.

V. Conclusion

In contrast to the condition in advanced countries, foreign investors do not
actively participate in the domestic bond market in the Republic of Korea. Cependant,
foreign investors actively participate in the domestic stock market. Basé sur ceci
phenomenon, some past studies argue that a monetary contraction may depreciate
the domestic currency when the standard bond market channel does not work. Dans
addition, foreign investors may withdraw money from the domestic stock market
after a monetary contraction. Against this backdrop, this study examined the effects
of monetary policy shocks on the exchange rate in the Republic of Korea using
structural VAR models with sign restrictions.

Empirical results show that a monetary contraction appreciates the exchange
rate in the short run as predicted by standard theory. To explore the channels by

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134 ASIAN DEVELOPMENT REVIEW

which monetary policy shocks affect exchange rates, the effects of these shocks
on various components of capital ﬂows were examined. Consistent with standard
theory such as the uncovered interest parity condition, the study found a signiﬁcant
increase in capital inﬂows to the bond market. This seems to be the main channel
by which monetary contraction appreciates the domestic currency. Cependant, ce
result contradicts the argument that the bond market channel may not work because
of weak participation of foreign investors in the domestic bond market. Empirical
results also show that capital inﬂows tend to decrease in the stock market, which is
similar to the claim of some past studies. Cependant, the bond market channel seems
to dominate the stock market channel because domestic currency appreciates under
monetary contraction.

Since the Asian ﬁnancial crisis in 1997, several policy makers and researchers
have argued that emerging Asian economies suffer from the lack of strong monetary
transmission mechanisms. They suggest that investors do not respond strongly to
monetary expansion and the resulting decline in interest rates because ﬁrms have
become conservative after experiencing the devastating ﬁnancial crisis.

Even if the interest rate or investment channel does not work, the empirical
results suggest that an alternative channel for monetary policy, c'est, the exchange
rate channel, is likely to work. Many Asian countries, including the Republic of
Korea, adopted a regime with a more ﬂexible exchange rate and a more open capital
account. Under such an environment, the interest rate channel becomes weaker but
the exchange rate channel becomes stronger.12

The policy environment of emerging economies will undergo rapid changes
in the future. Emerging economies are likely to be more ﬁnancially interconnected
with the rest of the world as foreign investors participate more actively in the
bond market and as domestic investors vigorously pursue outside opportunities.
This environment will lead to another challenge for policy makers of emerging
économies. Policy makers should be aware of the changes in policy environments
and should have a clear understanding of the effects of changes in policies.

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Stabilization in Korea, Malaisie, et la Thaïlande: An Empirical Investigation of the Traditional
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Eichenbaum, Martine, and Charles L. Evans. 1995. Some Empirical Evidence of Shocks to Mone-
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changes in credit availability following monetary policy may be important for countries where short-term and long-
term interest rates are not closely tied together.

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