Analysis of Short-term Exchange Rate Movements in Korea: Application of an Extended Mundell-Fleming Model

Extending the Mundell-Fleming model and applying the Newey-West HAC method, this paper finds that the real USD/won exchange rate is negatively affected by real M2, the world interest rate, country risk, the expected inflation rate and the binary variable for the time period during the Asian financial crisis, and positively influenced by the stock market performance and the lagged dependent variable. The coefficient of real government deficit spending is positive but insignificant at the 10% level. Therefore, to maintain the stability of the won, the authorities need to pursue expansionary monetary and fiscal policies with caution, nurture a positive business and investment environment to reduce country risk, maintain a healthy stock market, and enhance the central bank's credibility to lower inflation expectations.