Authour : Sung Min Mun(Bank of Korea), Byoung-Ki Kim(Bank of Korea)

<Abstract>

This paper studies, from a quantity theory of money perspective, the reasons that North Korean inflation and exchange rates maintain stability while its economy is experiencing difficulties due to the international community’s economic sanctions. In doing so, this paper uses both domestic and foreign currencies in an analytic model based on the quantity theory of money to cautiously reflect North Korea’s dollarization as well as its management of its exchange rate. In particular, foreign currency holdings are divided into those for store-of-value purposes and those for transaction purposes. This paper shows that in the early stages, in which the amount of foreign currency holdings for store-of-value purposes is decreasing while the amount of foreign currency holdings for transaction purposes is intact, inflation and exchange rates both exhibit stable movements. In the middle stages, where the amount of foreign currency holdings for transaction purposes begins to fall, exchange rates show some increase and inflation decreases. In the final stages, when the amount of foreign currency holdings for transaction purposes significantly decreases, exchange rates and inflation both increase, and in some situations a crisis can happen. According to this paper’s analysis, if the economic sanctions continue to the extent that the amount of North Korean foreign currency holdings for transaction purposes starts to fall, the exchange rate and inflation stability we see now are unlikely to be maintained.