 External Supply Shocks and the Optimal Interest Rate Rule in an Open Economy (in Korean)Geun-Young Kim ()
Economic Analysis (Quarterly), 2008, vol. 14, issue 3, 1-45 Abstract: Inflation and output move in opposite directions under an external supply shock such as a rise in imported raw material prices. Because of this conflicting movement, the monetary authority confronts a difficulty that two of its policy goals - between price and economic stability - are in conflict. The paper attempts to derive the optimal interest rate rule of the monetary authority responding to the external supply shock from the perspective of maximizing social welfare, using a New Keynesian model. In constructing the model, the paper takes into account the characteristics of the standard new open economy macroeconomic model, such as imperfect competition and nominal price rigidity. In addition, the research takes account of the low elasticity of substitution between domestic intermediate goods and imported raw materials, and the asymmetry of price-setting between import and export goods so that the model conforms with the Korean economic structure. According to the analysis, the optimal interest rate rule, under circumstances where the uncertainty of international prices of imported goods mounts higher, sets inflation and output coefficients at 3.1 and 1.1, respectively. This signifies that an interest rate rule putting more weight on inflation can be optimal while taking into account inflation and the output gap at the same time. As the sustainability or uncertainty of the supply shock becomes greater, moreover, strengthening the response to inflation is analyzed to be desirable from the social welfare aspect. Furthermore, the effects of the rise in imported raw material prices on macroeconomic variables are examined via an impulse response analysis. When the optimal interest rate rule is followed, interest rates increase after the supply shock and then inflation stabilizes. As a result, the real sector such as production and consumption appears to recover gradually. The result implies that under an external supply shock, the monetary authority should conduct a systematic and explicit monetary policy based upon accurate understanding and judgement as to the degree, uncertainty and sustainability of the shock. In this case, the negative effects of the shock on the economy can be minimize. Keywords: supply shock; open economy; New Keynesian model; optimal interest rate rule; monetary policy (search for similar items in EconPapers) Downloads: (external link) Related works: Export reference: BibTeX RIS (EndNote, ProCite, RefMan) HTML/Text Persistent link: https://EconPapers.repec.org/RePEc:bok:journl:v:14:y:2008:i:3:p:1-45 Access Statistics for this article Economic Analysis (Quarterly) is currently edited by Wook Sohn, Hwan-koo Kang and Jaerang Lee More articles in Economic Analysis (Quarterly) from Economic Research Institute, Bank of Korea Contact information at EDIRC. |
Is your work missing from RePEc? Here is how to contribute.
Questions or problems? Check the EconPapers FAQ or send mail to .
EconPapers is hosted by the
School of Business at Örebro University.