The Korean Journal of Economic Studies
Interest Rate Differential and Capital Flows: A Theory and Empirical Analysis
Youngjin Yun (The Bank of Korea) and Jongwook Park (The Bank of Korea)Year 2019Vol. 67No. 2
We study the effect of interest rate differential between Korea and US oncapital flows of Korea. We first build a simple small open economy modelwhich shows that the capital flow is a function of interest rate differential,growth and financial friction. Guided by the model, we empirically test theeffect of interest rate differential on capital flows using the financial account ofmonthly balance of payment data of Korea from 2002 to 2018. Deploying theautoregressive distributed lag model and the local projection method, we findthat capital flows of Korea became more sensitive to interest rate differentialafter the Global Financial Crisis. The effect is mainly coming from residentbanks’ borrowing from abroad, and non-residents’ bond investment. The smallopen economy model suggests that this may be a result of reduced barriers tointernational capital flows and economic growth.