Monetary Policy Responses to Large Capital Inflows and Domestic Interest Rates: The Case of Asian Crisis Countries prior to the Crisis

Abstract

This study tries to implicate that the excessively high domestic interest rates in four Asian crisis countries (Indonesia, Korea, Malaysia, and Thailand) are a result of policy responses to a large capital inflow, during the pre-crisis period. The preliminary results indicate that the interest rates in Asian crisis countries during the pre-crisis period are excessively high. Using the standard IS-LM-BP model as a theoretical model, solutions for interest rates were derived from two different systems (first, when monetary authorities continuously sterilize capital inflow; second, when monetary authorities constantly pursue monetary policy rules to stabilize the domestic economy). Vector error correction model (VECM) is chosen to empirically illustrate the positive influence of monetary policy responses to capital inflow on domestic interest rates. The results are notably robust, and suggested that the monetary policy responses to the large capital inflow in the pre-crisis period for four Asian crisis countries were the reason behind the excessively high domestic interest rates.