A Comparison of Monetary Policy Rules for a Financially Vulnerable Economy : The Case of Korea

A small, open macro model with new transmission channels is developed to account for the post-crisis structural changes and to evaluate various policy rules for inflation targeting. Given significant changes in transmission channels and the lingering fragility in the financial sector, policy response itself can seriously accentuate the endogenous financial accelerator effect. Under the prevailing policy constraints, various forms of inflation targeting with emphasis on long-term inflation expectations, output changes, and the asset price channels are compared using simulation results based on a newly constructed model. It turns out that successful outcome is obtained by adhering to forward-looking simple rules in favor of backward-looking comprehensive policy rules. Above all, even with the dominant role of financial vulnerability in emerging market developments, simulation studies reveal that price as well as output stability that can be better achieved under a certain type of policy rules by helping to keep the financial accelerator from being activated. A further caveat for implementing inflation targeting in emerging economies is to use it as a unifying policy framework in which the environment for long-term capital market development can be promoted