The Impact of Monetary Tightening on the Won/Dollar Exchange Rate

This study examines the impact of the widening interest rate differential between Korea and the U.S. on the won/dollar exchange rate. Reflecting characteristics of the Korean economy such as its small open economy, currency and financial crises, and structural economic changes, I estimate VAR models and ECMs, treating the dollar index and oil prices as exogenous variables alongside dummy variables. The impulse response analysis reveals that during the pre-currency crisis period (April 1990–October 1997), an upward shock to (call rate - federal funds rate) caused industrial production and consumer prices to decline while increasing the won/dollar exchange rate. From the post-currency crisis period to the pre-global financial crisis period (January 1999–August 2008), a price puzzle phenomenon emerged during monetary tightening shocks, and the won/dollar exchange rate exhibited an inverse U-shaped response. However, from the period when Korea became a net external financial asset holder until recently (January 2014–May 2025), monetary tightening shocks have caused both prices and the won/dollar exchange rate to decline. Because the effects of increased liquidity demand and deflation outweigh the effect of reduced industrial production, a so-called “advanced-economy-type forward premium puzzle” emerges—in which a monetary tightening shock causes the domestic currency to appreciate—contrary to the claims of existing international studies.