Alternative Monetary Policy Rules in a Small Open Economy with Financial Frictions: The Case of Korea

Abstract

This paper first shows an empirical result of VAR that Korean economy has experienced a severe economic contraction to an exogenous country spread shock. To analyze the effect of alternative monetary policy on the economy, the paper sets up a multi-sector small open economy new Keynesian (NK hereafter) model with financial frictions due to asymmetric information between firms and financial intermediaries along the line of Bernanke et al. (1999). It shows that the small economy with financial frictions is more vulnerable to the exogenous shocks such as the foreign exchange rate shock under the fixed exchange rate regime than under the flexible exchange regime. It also shows that the interest rate rule that responds to financial market conditions is better than any other interest rate rules only if it does not react to the exchange rate fluctuations. Moreover, an interest rate rule that responds to the exchange rate fluctuations, i.e. the monetary policy under the managed floating exchange rate regime is inferior to the monetary policy rules that do not respond to the exchange rate fluctuations. Finally, it shows that the monetary authority needs to stabilize a narrow price index such as domestic price index rather than a general price index such as consumer price index under the financial friction circumstances.