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Capital Inflows and Exchange Rate Volatility in Korea

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  • Kyuil Chung

    (The Bank of Korea)

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    Abstract

    High exchange rate volatility threatens international trade and exacerbates the currency mismatch problem, hence generating economic instability. However, low exchange rate volatility may cause another problem. Low volatility induces speculative capital inflows as speculative investors, who are usually concerned both with the interest rate differential and exchange rate risk, become concerned with the interest rate differential only. In this paper we use several techniques to identify the relationship between exchange rate volatility and capital inflows in Korea. First, estimation of a Markov switching model shows that all kind of capital inflows increase under low volatility regimes, while capital inflows with the exception of FDI all decrease under high volatility regimes. Second, estimation of a multivariate GARCH-in-Mean Model and the impulse response function derived from it provide evidence that lower exchange rate volatility tends to increase most types of capital inflows other than FDI. These results imply that a medium level of exchange rate volatility is most beneficial for economic stability

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    Paper provided by Society for Economic Dynamics in its series 2013 Meeting Papers with number 890.

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    Date of creation: 2013
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    Handle: RePEc:red:sed013:890

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    1. Edwards, Sebastian & Rigobon, Roberto, 2009. "Capital controls on inflows, exchange rate volatility and external vulnerability," Journal of International Economics, Elsevier, vol. 78(2), pages 256-267, July.
    2. Guillermo A. Calvo & Leonardo Leiderman & Carmen M. Reinhart, 1996. "Inflows of Capital to Developing Countries in the 1990s," Journal of Economic Perspectives, American Economic Association, vol. 10(2), pages 123-139, Spring.
    3. Elder, John, 2003. "An impulse-response function for a vector autoregression with multivariate GARCH-in-mean," Economics Letters, Elsevier, vol. 79(1), pages 21-26, April.
    4. Chowdhury, Abdur R, 1993. "Does Exchange Rate Volatility Depress Trade Flows? Evidence from Error-Correction Models," The Review of Economics and Statistics, MIT Press, vol. 75(4), pages 700-706, November.
    5. John Elder & Apostolos Serletis, 2010. "Oil Price Uncertainty," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 42(6), pages 1137-1159, 09.
    6. Koray, Faik & Lastrapes, William D, 1989. "Real Exchange Rate Volatility and U.S. Bilateral Trade: A VAR Approach," The Review of Economics and Statistics, MIT Press, vol. 71(4), pages 708-12, November.
    7. Kroner, Kenneth F. & Lastrapes, William D., 1993. "The impact of exchange rate volatility on international trade: Reduced form estimates using the GARCH-in-mean model," Journal of International Money and Finance, Elsevier, vol. 12(3), pages 298-318, June.
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