It is interesting that, just a few years ago, strong countercyclical policy actions of the type taken by Korea would not have been recommended for an emerging market country during a period of crisis, and might not even have been feasible. In earlier crises, foreign investors were not inclined to give emerging market policymakers the benefit of the doubt when they promised low inflation and sustainable fiscal policies. Attempts to support economic activity through conventional expansionary policies thus risked a vicious circle of capital flight, exchange rate depreciation, higher inflation, a worsening balance of payments, and more capital flight. As a result, monetary policymakers in emerging markets often reacted to crises--such as the Asian financial crisis of the late 1990s--by raising rather than lowering policy rates, in order to defend the value of the currency, slow capital flight, and bolster the credibility of monetary policy. Likewise, the scope for fiscal expansion was severely limited by concerns about medium-term fiscal sustainability.
Why was this crisis different? In particular, why was the Bank of Korea able to respond in a countercyclical manner this time, reducing rather than raising the policy rate in response to the downturn? One important difference, of course, was that this crisis originated in advanced economies, not in the emerging market economies. Financial institutions in Korea and other emerging market economies had little direct exposure to structured credit products and other troubled securities and entered the crisis in relatively sound condition.
In addition, following the Asian financial crisis in the late 1990s, Korea and a number of other countries in Asia, Latin America, and elsewhere took decisive steps to strengthen their macroeconomic frameworks and financial systems...
Improvements in the Bank of Korea's monetary framework served the country well during the crisis and are likely to provide additional benefits in the future. Over the past decade, many emerging market economies, including Korea, have reoriented monetary policy toward domestic price stability and away from a focus on stabilizing exchange rates. The Bank of Korea, indeed, adopted a formal inflation targeting regime in 1998. Since then, the exchange value of the won has become more flexible, inflation has declined to an average of about 3 percent, and--as I have discussed today--the ability of the Bank to conduct appropriate countercyclical monetary policies has increased.