Capital Liberalization and Imperfect Substitutability between Bonds and Stocks: Reexamination of the Mundell-Fleming Model

Tae-Joon Kim () and Jai-Won Ryou ()
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Tae-Joon Kim: Dongduk Women's University
Jai-Won Ryou: Konkuk University

East Asian Economic Review, 2002, vol. 6, issue 1, 3-28

Abstract: This paper analyzes the effects of macroeconomic policies and foreign shocks on the stability of a small open economy, in which equity investment is more crucial than debt investment. The key assumption of our model is that stocks and bonds are imperfect substitutes. Accordingly, financial market equilibrium in our model is achieved only when both money and stock markets are simultaneously in equilibrium. In contrast to the Mundell-Fleming model, fiscal policy is relatively effective under the flexible exchange rate regime, while monetary policy is relatively effective under the fixed exchange rate regime. In the case of foreign shocks such as hike of world interest rates, the flexible exchange rate regime appears more effective in stabilizing the economy because the flexible exchange rate functions as a shock absorber. The empirical evidence from the Korean economy during 1998:4- 2000:11 supports these findings. After the 1997 currency crisis, the Korean monetary authorities adopted the independently floating exchange regime and fully liberalized the capital account. Using a vector autoregressive model consisting of money stock, interest rate, balance of payments and exchange rate, we analyze the effect of an expansionary monetary policy. An increase in money supply decreases the domestic interest rates but the balance of payments turns into surplus. This result confirms that the higher rates of return on equity results in net capital inflows, in spite of lower domestic interest rates, and thus appreciates the domestic currency.

Keywords: Mundell-Fleming Model; Bonds And Stocks Market: Capital Liberalization: Korea (search for similar items in EconPapers)
JEL-codes: F31 G15 (search for similar items in EconPapers)
Date: 2002
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