Interest Arbitrage and Interest Rates in Korea

Contractionary monetary policy reduces the price level in the long run, but it is frequently observed that a positive interest rate shock raises the price level at a short horizon. Impulse response analysis and estimation of an interest rate augmented Phillips curve in Korea indicate the existence of a cost channel effect of monetary policy before the currency crisis period. Based upon these empirical results, this paper develops a dynamic stochastic general equilibrium model in order to explain the price responses in Korea. The cost channel of monetary policy transmission is a key feature in the model. Moreover, in order to examine the role of the banking sector in the monetary policy transmission given cost channel, an explicit loan production function in the banking sector is introduced. I find from policy simulation that the cost channel effect of monetary policy has fallen dramatically since the currency crisis in 1997. The model suggests that this result comes mainly from the facts that it takes longer for firms to adjust their output prices, and that the capital adjustment cost has declined since the currency crisis. I also find that, despite the existence of the cost channel, when the banking sector supplies loans efficiently, monetary policy has an effect on the economy mainly through the change of aggregate demand. This implies that, given the existence of the cost channel, the central bank can reduce undesirable output price movements by enhancing the efficiency of the banking sector.