Macroeconomic Effects of South Korea's Monetary Policy

Running head: MACROECONOMIC EFFECTS OF MONETARY POLICY

Macroeconomic Effects of a Tightened Monetary Policy on the South Korean After the 1997 Asian Financial Crisis

Erica Teryse Gonzales

SS111 LBA

Within just 60 years, South Korea transformed from one of the world’s poorest countries to the 11th largest economy in the world (GDP ranking, 2017). Due to this rapid economic development, South Korea is often cited as a paragon for current developing countries. In 1997, the nation was affected by the Asian Financial Crisis. In response to the crisis and with the help of the International Monetary Fund, South Korea revised the Bank of Korea Act to now focus on price stability through inflation targeting and tightened monetary policy. Despite a contracting economy in the short-term, this policy change saved the South Korean economy.^[1]

Policy Reform: Tightened Monetary Policy and Inflation Targeting

        In 1997, the Asian Financial Crisis began in Thailand when the nation decided to no longer peg their bhat to the U.S. dollar, triggering a series of currency devaluations across East Asia (Baliño & Ubide, 1999). Seeing this trend, foreign investors withdrew from the Korean economy, thus reducing capital inflow and depreciating the Korean won by 14% (Baliño & Ubide, 1999). Due to foreign banks’ increased refusal to lend, the accumulating short-term foreign debt of the chaebols (powerful conglomerates that dominated the Korean economy) who were low in profitability and unable to pay their debt, and the weak infrastructure of the banks dependent on the chaebols, the country fell into an economic crisis as more chaebols experienced bankruptcy (Baliño & Ubide, 1999). This was a failure on the government for it allowed the economy to become dependent on the chaebols.^[2][3]

To prevent the nation’s economy from completely collapsing, the IMF provided a bailout worth US$57 billion. In exchange, the Bank of Korea (BOK) was required to tighten their monetary policy and reform the banking system to control the chaebol. After the revision of the Bank of Korea Act in 1998, the bank’s sole purpose became price stability that will be achieved through inflation targeting.

Macroeconomic Effects

To stabilize the value of the Korean won in the exchange market and to attract foreign investors, the BOK raised interest rates to 30% (Lee, 1999). As a consequence, it also reduced domestic economic activity; in 1998, private consumption decreased by 12.5% and private investment decreased by 22.4% (Lee, 1999). The real GDP had a -3.6% growth rate (Lee, 1999). In that same year, the unemployment rate increased from 3% to 7.9%; 1.66 million jobs were lost (Lee, 1999). However, the increased interest rate was not a government failure, at least in the long-term, as will be explained later.