An examination of macroeconomic fluctuations in Korea exploiting a Markov-switching DSGE approach

- Introducing inflation targeting in Korea has contributed to a sharp drop in the level as well as the volatility of inflation.
- Technology shocks are the most important drivers of output fluctuations in Korea.
- Higher output and lower inflation could have been achieved if the inflation targeting was maintained over the entire period.

This paper estimates a Markov-switching dynamic stochastic general equilibrium (MS-DSGE) model that allows shifts in the monetary policy rule coefficients as well as the shock volatilities with Korean data ranged from 1976 to 2013. We find that allowing for the regime-switching aspect both in monetary policy rules and shock volatilities is a crucial setup in improving the model's fit with Korean data. The regime estimates indicate that monetary policy more aggressively reacts to inflation, but less strongly to output, after launching the Inflation Targeting (IT) policy in the late 1990s. The identified regimes have three implications on macroeconomic performance in Korea. First, the introduction of the IT monetary policy has contributed to a sharp reduction in the level as well as the volatility of inflation in the 2000s. Second, technology shocks are the most important drivers of output fluctuations in Korea as the major economic crises in Korea are mainly explained by adverse shocks on technology. Finally, it would have been possible to achieve higher output and lower inflation simultaneously if the IT monetary policy regime was maintained over the entire sample period.