Inflation Targeting in a Stable Growth Economy : The Korean Experience

Abstract

In an economy characterized by stable growth and low Inflation, the slope of a non-linear Phillips curve may become Flatter, As a result, the degree of sacrifice of employment needed to reduce the inflation rate increases. Therefore, it is necessary to carry out inflation targeting monetary policy more flexibly including a careful reexamination of both the target inflation rate to restore economic growth toward full employment and of the appropriate level of interest rate to achieve the target inflation rate. The costs of reducing inflation as well as the benefits of doing so should be taken into account together in a balanced manner. An optimal target rate of inflation becomes more important in escaping from unnecessary unemployment. In this regard, the form of the Phillips curve has important implications for monetary policy. In Korea, a non-linear Phillips curve is estimated to be concave. The estimated full employment rate of inflation (FERI) is still within the upper bound of the band of the current target inflation rate and. according to the simulation result, the level of the current rate of interest seems reasonable. Statistically, however, the output gap is only insignificantly influenced by a change in the interest rate mainly because the demand elasticity of interest rate had been almost negligible since the 1997 financial crisis. Therefore, recovering the investment elasticity of interest rates has now emerged as an important issue.