Academic journal article International Journal of Management

The Financial Implications of a VAR Model of the Determinants of Exchange Rates: The Case of South Korea

Academic journal article International Journal of Management

The Financial Implications of a VAR Model of the Determinants of Exchange Rates: The Case of South Korea

Article excerpt

Applying a VAR model based on a sample from 1981.Q1 - 2002.Q3, the nominal exchange rate in Korea was found to have a positive response to a shock to the U.S. output, real budget deficits, the price level in the U.S., and its own lagged values. The exchange rate reacts negatively to a shock to output in Korea, the interest rate differential between the U.S. and Korea, and the price level in Korea. Second only to lagged exchange rates, the price level in Korea had a very significant impact on the movement of exchange rate. The interest rate differential and government deficit are considerable factors as well, explaining up to 8.6% and 7.9% of the variation in exchange rates, respectively. By evaluating the simultaneous differential equations, exchange rate and interest rate differentials are proven to follow certain paths toward conditional equilibrium. The model and empirical results can provide insights for multinational companies in developing a business strategy that better controls the exchange rate risk of Korean won.

Introduction

In the deep turmoil of the Asian financial crisis, the Korean won per U.S. dollar depreciated by 78.6% from 899 in 1997.Q3 to 1,606 in 1998.Q1. The substantial depreciation had mixed impacts on the Korean economy. The depreciation stimulated the export growth by as much as 17.0% and discouraged imports by as much as 25.4% during the that time period, since Korean-made goods were cheaper than the foreign goods. Higher import prices triggered the domestic price level to rise from 109.99 to 1 17.46 during 1997.Q3 - 1998.Q1 and the inflation rate to surge from 1.45% in 1997.Q4 to 5.26%) in 1998.Q1. Furthermore, higher prices reduced real income and wealth, which in turn caused household consumption and aggregate demand to decline.

In light of these severe consequences from the falling currency, the Korean government took several measures to stabilize the economy. The Bank of Korea pursued a tight monetary policy by raising the domestic money market rate from 12.38%; in 1997.Q3 to 23.93% in 1998.Q1, hoping that such policy would increase the appeal of the Korean assets in the financial market to prevent capital flight. Because of tight monetary policy and high interest rates, inflation rates were under control after 1998.Q1. An expansionary fiscal policy was issued as well. The Korean government increased its spending, incurred a budget deficit of 4,044 billion won in 1997.Q4, in an attempt to slow down the depreciation of the won. As a result of these measures and other relevant factors, the won has appreciated to 1,198 in 2002.Q3.

The paper reexamines the determinants of exchange rates for Korea, and adds new aspects to the previous studies. It includes major policy variables such as fiscal and monetary policies to avoid potential problems of omitted variables. In the case of Korea, the government imposed a tight monetary policy and an expansionary fiscal policy in an attempt to stabilize the exchange rate. At issue of this study is to assess how effective these measures were and which policy delivered better results. Another focus is to analyze how much impact prices have on the exchange rate; our work separates the domestic and foreign prices to explore their potentially different effects on exchange rates. A system of two simultaneous equations is also employed to evaluate the impact of interest rate policy on exchange rate stability of an economy. The data sample extends to 2002.Q3 and covers the interval of the Asian financial crisis, thus providing more extensive policy implications. A single equation for the exchange rate may not reflect the interrelationships among all the variables and may have the problem of simultaneity bias. Therefore, the VAR model is employed to estimate the system equations to reflect potential dynamic relationships among all the variables. Impulse response functions are estimated to measure how exchange rates would react to a shock to one of the endogenous variables in the system. …

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