TITLE : [Economic Papers 5-2]
          The Effect of Uncertainty on Monetary Policy in Korea
AUTHOR : Min Chang and Jean Lim
CONTACT : Institute for Monetary & Economic Research
             (tel: 82-2-759-5407, 5421 fax: 82-2-759-5410)
ATTACH : EP5-2-01.pdf


Summary:

With the introduction of an inflation targeting regime after the currency crisis, the Bank of Korea shifted the emphasis of monetary policy from monetary aggregates to interest rates. Under this monetary policy regime, in case that the deviation of inflation from a target range is predicted by observing various information variables, it is important for central banks to adjust policy rates preemptively. Therefore, the central bank must be capable of forecasting the future economic situation. In reality, however, since the future economy is uncertain and greatly affected by various factors, there are many difficulties in forecasting the future economic situation in order to carry out monetary policy effectively. The paper sets out both to track an optimal call rate path by introducing multiplicative uncertainty to an economic model, and to analyze empirically the effect of uncertainty on monetary policy in Korea. The result is that if uncertainty is present, it is desirable to operate an interest rate policy gradually. It also shows that the path of the actual call rate is similar to that of the optimal call rate under multiplicative uncertainty. In short, if the monetary authorities implement monetary policy taking future uncertainty into consideration, interest rates will adjust gradually, even though interest rate smoothing is not an objective of monetary policy.