Empirical tests on the intermediate targets of monetary policy: The case of Korea

This study attempts to identify appropriate financial variables as intermediate target variables of monetary policy in Korea on the basis of the information variable approach. For this purpose, we investigate the information content of alternative monetary aggregates, the interest rate and the foreign exchange rate for future movements of real income and prices by using autoregression tests and variance decompositions. Moreover, since intermediate target variables should be ultimately related to final target variables, we also analyze a long-run relationship between real income and the prospective intermediate target variables by employing the cointegration method.; Results from autoregression tests and variance decompositions show that money, the interest rate (the corporate bond rate) and the foreign exchange rate all contain significant information about future fluctuations of real income and prices in the short-run. On the other hand, cointegration tests indicate that only when money is broadly defined by M3 as total liquidity, there exists a unique long-run equilibrium relationship between real income and the prospective intermediate target variables---namely, real M3, the corporate bond rate and the real exchange rate. This result implies that one or more of these financial variables could be used as intermediate target variables of monetary policy in Korea. However, the long-run responsiveness of real income to changes in M3 is more significant and greater than that of either the interest rate or the foreign exchange rate. In addition, the interest rate in Korea is not flexible while the foreign exchange rate is subject to external influences. Thus, the M3 monetary aggregate appears to be more appropriate than the interest rate and the exchange rate as the intermediate target variable of monetary policy in Korea.; The above findings have some policy implications. The evidence that M3, not M2, is the appropriate monetary indicator rejects the practice of controlling M2 which the Korean monetary authority has exercised before implementing the recent IMF financial reform package. The Korean monetary authority should emphasize M3 for monetary control. It is also suggested that different degrees of moneyness among the components of M3 is to be incorporated in monetary aggregation.