Should the central bank respond to the stock price volatility in the case of South Korea :Master thesis - Major: Investment Finance

SCHOOL OF ECONOMICS AND FINANCE

MSc in Investment and Finance

Should the central bank respond to the stock price volatility in

the case of South Korea?

Supervisor : Dr. Dario Maimone

Student’s name : Thi Hoai Tho Truong

Student’s ID : 130579517

Student’s email: [email protected]

Submission date: 22 August 2014

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ABSTRACT

In many past years, the inclusion of asset price misalignments in the monetary policy

model seems to be lack of consensus in policy makers. However, there are many pundits suggest

that changes in asset prices provide helpful information to examine and formulate monetary

policy. This paper will clear this confusion in the case of South Korea from 1980 to 2014.

Starting with the responsiveness of monetary policy to the changes of stock prices, once will

estimate the standard Taylor rule by using the OLS estimation, and the following is the

augmented Taylor rule with adding the effect of stock price misalignments. To be more evident,

some extension version of Taylor rule will be investigated. Specifically, the influence of

expected values of inflation and output gap on the interest rate have been proved by utilizing the

forward-looking model (Fuhrer and Tootell, 2008), and the causality relation between the interest

rate and stock prices will be found in the reserve causality test (Ribogon and Sack, 2002)

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TABLE OF CONTENT

ABSTRACT .................................................................................................................................... 1

LIST OF FIGURES ........................................................................................................................ 5

LIST OF TABLES .......................................................................................................................... 5

CHAPTER 1. INTRODUCTION ................................................................................................. 7

CHAPTER 2. LITERATURE REVIEW ...................................................................................... 9

CHAPTER 3. EMPIRICAL FRAMWORK ............................................................................... 13

3.1. The standard Taylor rule ................................................................................................ 13

3.2. The augmented Taylor rule ............................................................................................ 14

3.3. Generalized Methods of Moments (GMM) ................................................................... 14

3.4. Reverse Causality ........................................................................................................... 15

3.5. Forward-looking model .................................................................................................. 16

CHAPTER 4. DATA DESCRIPTION ....................................................................................... 17

4.1. Summary statistic ........................................................................................................... 17

4.1.1. The discount rate..................................................................................................... 18

4.1.2. Inflation and output gap.......................................................................................... 19

4.2. Correlation Matrix .......................................................................................................... 21

CHAPTER 5. EMPIRICAL RESULTS ..................................................................................... 22

5.1. The Standard Taylor Rule .............................................................................................. 22

5.1.1. Estimating the Standard Taylor rule by using ordinary least squared (OLS)

estimator ................................................................................................................................ 22

5.1.2. Chow Break test ...................................................................................................... 24

5.2. The Augmented Taylor Rule .......................................................................................... 25