Foreign Exchange Policy, Monetary Policy, and Capital Market Liberalization in Korea

Abstract

In this paper, I investigate the interactions between foreign­ exchange policy, monetary policy, and developments in Korean capital markets. A large increase in Korea's external position, combined with a relatively inflexible exchange rate, led to very large potential increases in money growth between 1986 and 1989. The sterilization of the foreign exchange intervention required an unprecedented monetary tightening on other fronts--a tightening that could have created serious distortions in the financial markets had direct credit controls been utilized. Consequently, the use of open market operations, rediscount policy, and reserve requirements was expanded and adapted to be more responsive to other market rates.In addition to its sterilization efforts in 1986-89, the Korean government allowed the won to appreciate against the dollar and liberalized some capital outflows, thereby reducing the external pressure for money growth. Additionally, in March 1990, the government introduced a more flexible exchange rate system that will help reduce future external pressure on the money supply. However, because daily changes in spot rates are currently limited, pressure on the money stock may occur again if market pressures for exchange rate changes exceed the allowed bands.