The Bank of Korea's adjustment of its Base Rate influences the entire economy through various channels. As these channels of transmission are long, complicated, and may vary depending upon economic conditions, it is difficult to measure accurately the influence of a change in the Base Rate on prices and its transmission lag. In general, however, it can be said that monetary policy is transmitted through the following channels:
Interest rate channel
An adjustment of the Base Rate affects interest rates in the financial markets as a whole, including short-term and long-term interest rates, and deposit and lending rates. For example, if the Bank of Korea raises its Base Rate, short-term interest rates such as overnight call rates rise immediately, deposit and lending rates show an underlying upward tendency, and long-term interest rates come under upward pressures. Such movements of various interest rates affect aggregate demand in the form of both consumption and investment. For instance, a hike in interest rates leads to a curb on borrowings, an increase in savings, rises in interest remuneration on deposits and on loans, and ultimately a decline in household consumption. This also applies to businesses. Ceteris paribus, an increase in interest rates raises financial expenses and accordingly reduces investment.
Asset price channel
A change in the Base Rate also influences prices of assets including stocks, bonds and real estate. For instance, if the Base Rate rises, the present value of future profits to be gained through assets such as stocks, bonds and real estate declines, and asset prices accordingly go down. This leads to a decrease in households' assets, or wealth, serving as a factor in bringing down household consumption.
An adjustment of the Base Rate also influences banks' lending behavior. For example, if there is a Base Rate hike, banks may become even more prudent than before in lending, concerned about the redemption capacity of borrowers. This dampens both investment by businesses raising funds through bank loans and credit-based consumption by households.
Exchange rate channel
A change in the Base Rate affects the foreign exchange rate as well. For instance, if the Base Rate rises in Korea while rates in other countries remain unchanged, returns on Korean won-denominated assets will increase relatively, which will attract foreign capital. As the number of persons hoping to purchase Korean won-denominated assets grows, the won will appreciate. Its appreciation will bring down prices of imported goods and services and demand for them will accordingly grow. This will in turn push up prices of export goods denominated in foreign currency, which will lead to a decline in overseas demand for Korean goods and services.
⇒ These changes in aggregate demand, in the form of consumption, investment and exports (overseas demand), through various channels again affect prices. For instance, a fall in aggregate demand, in terms such as consumption, investment and exports, following a hike in the Base Rate, serves to put downward pressure on prices. In the exchange rate channel, in particular, a fall in Korean won-denominated import prices resulting from the won's appreciation serves as a direct factor in bringing down domestic consumer prices.
An adjustment of the Base Rate leads to a change in inflation expectations, consequently affecting prices. For example, an increase in the Base Rate is interpreted as showing the Bank of Korea's resolve to reduce price inflation, which brings inflation expectations down. This consequently influences firms' setting of their product prices and wages, as a result pulling real price inflation down.
Monetary Policy Transmission Mechanisms
Meanwhile, as national economies are currently being absorbed rapidly into the global economy, and economic structures and the behavior of economic agents are changing fast, it is very difficult to gain an accurate grasp of how the monetary policy transmission channels are working and changing. The Bank of Korea constantly monitors whether these channels are working properly and strives to ensure that the effects of monetary policy are transmitted to the financial markets and the real economy.