Given that the degree of exchange rate volatility can change at any time and such change can deliver shocks to the economy, this paper analyzes the influence of Korean exchange rate volatility on major economic variables. According to an empirical analysis through vector autoregression model (VAR) of the relationship between volatility defined using daily foreign exchange data and major economic variables, exchange rate volatility shocks are seen to have an empirically
significant influence on major economic variables by bringing about falls in consumption, investment, employment and production.
In addition, in order to see if these empirical analysis results can be significantly explained within a small-open economy DSGE model framework, this paper sets exchange rate volatility as a shock variable within the model. In other words, the results of the analysis of the influence of exchange rate volatility shocks on individual economic variables through Higher Order Approximation by introducing a UIP error term show a response similar to the results of the above empirical analysis. For instance, consumption, investment, employment and production all decline. These results are considered to obtain because within a model reflecting the characteristics of a small-open economy, households respond to future uncertainty by increasing precautionary savings against volatility shocks.
Putting together the empirical and model analysis results, exchange rate volatility has a significant influence on the Korean economy, which implies that volatility shocks can have as great an influence on major macro variables as real sector shocks. In addition, these results imply that it is important to have a policy response to minimize the negative effects of exchange rate volatility shocks in Korea, since its financial market volatility changes rapidly in line with the
movements of overseas variables, due to its high degrees of external dependence and capital market openness. To this end, along with stable operation of macroeconomy, there is a need for policy efforts including the active use of foreign exchange and macroprudential policies, the mitigation of exchange rate volatility through micro adjustment of the FX market, when needed, and also for efforts to upgrade the FX market.