Capital Inflows and Exchange Rate Volatility in Korea

Kyongwook Choi (), Kyuil Chung () and Seungwon Kim ()
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Kyongwook Choi: University of Seoul
Kyuil Chung: International Economic Studies Team, Economic Research Institute, The Bank of Korea
Seungwon Kim: Personnel & Administration Department, the Bank of Korea

No 2012-16, Working Papers from Economic Research Institute, Bank of Korea

Abstract: High exchange rate volatility threatens international trade and exacerbates the currency mismatch problem, hence generating economic instability. However, low exchange rate volatility may cause another problem. Low volatility induces speculative capital inflows as speculative investors, who are usually concerned both with the interest rate differential and exchange rate risk, become concerned with the interest rate differential only. In this paper we use several techniques to identify the relationship between exchange rate volatility and capital inflows in Korea. First, estimation of a Markov switching model shows that all kind of capital inflows increase under low volatility regimes, while capital inflows with the exception of FDI all decrease under high volatility regimes. Second, estimation of a multivariate GARCH-in-Mean Model and the impulse response function derived from it provide evidence that lower exchange rate volatility tends to increase most types of capital inflows other than FDI. These results imply that a medium level of exchange rate volatility is most beneficial for economic stability.

Keywords: Exchange rate volatility; Capital inflow; Markov switching model; Multivariate GARCH-in-Mean Model (search for similar items in EconPapers)
JEL-codes: F31 F32 (search for similar items in EconPapers)
Pages: 22 pages
Date: 2012-12-28
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