East Asian Economic Review

Korea Institute for International Economic Policy (대외경제정책연구원)
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Monetary Policy Independence during Reversal Phases of Domestic-Foreign Interest Rate Differentials

  • Kyunghun Kim (Hongik University)
  • Received : 2024.02.28
  • Accepted : 2024.04.09
  • Published : 2024.06.30
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Abstract

This study examines how the independence of monetary policy changes in situations where the interest rate differential between domestic and foreign rates inverts, utilizing the trilemma indices. For analysis, this paper uses the trilemma indices developed by Kim et al. (2017) to analyze the relationship between the monetary policy independence index and the other two trilemma indices, namely the capital account openness index and the exchange rate stability index, across 45 countries from 2002 to 2018. The analysis reveals that the trilemma's validity is contingent. In particular, no statistically significant negative correlation was found between the monetary policy independence index and exchange rate stability index during periods of interest rate differential inversion. A positive correlation emerges between exchange rate stability and the independence of monetary policy, particularly when the inverted interest rate differential exceeds a certain threshold. This situation, where the exchange rate remains stable despite low domestic interest rates, implies that the central bank is effectively managing monetary policy to appropriately respond to economic conditions, which is reflected in the monetary policy independence index.

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Acknowledgement

This work was supported by 2021 Hongik University Research Fund. I would like to thank three anonymous referees for their insightful comments.

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