## Monetary–Fiscal Policy Interactions in Korea: A QPM-Based Analysis — Introduction

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---

### Korea’s fiscal and monetary challenges
- Rapid population aging (among the fastest in the OECD) and moderating potential growth raise long-term fiscal sustainability concerns.
- Proposed fiscal framework (under consideration since 2021-22) would target:
  - government debt-to-GDP ratio ceiling of 60 percent; and
  - a fiscal deficit cap of 3 percent of GDP.
- The Bank of Korea operates with a 2 percent inflation target.
- Recent episodes highlighted interaction issues between fiscal support and monetary tightening (COVID-19 support, policy-rate reductions, and the 2021-2022 inflation surge).

### Objectives and contributions of the paper
- Develops a Quarterly Projection Model (QPM) for Korea with an integrated fiscal block to analyze monetary–fiscal interactions.
- Extensions to standard New Keynesian semi-structural “gap” QPMs include:
  - separate inflation dynamics for core, food, and energy components;
  - exchange rate dynamics via a modified uncovered interest parity with a country risk premium; and
  - a fiscal block with stock-flow consistency and an endogenous debt-stabilizing fiscal rule.
- Enables analysis of how a medium-term fiscal anchor (e.g., a 60 percent debt ceiling) affects macro stability and debt sustainability.

### Theoretical framework and modeling approach
- QPM focuses on gaps (deviations from long-run equilibrium) for output, inflation, interest rates, and exchange rates.
- Monetary policy: forward-looking Taylor rule with smoothing responding to inflation deviations and the output gap.
- Fiscal block: captures primary deficits, interest payments, debt accumulation, and a fiscal rule responding to debt deviations.
- Fiscal impulse enters the IS curve as a reduced-form demand effect; debt dynamics and fiscal credibility feed back into financial conditions via an expected-debt term.

### Fiscal policy design in the model
- Fiscal rule specification:
  - Structural primary deficit adjusts in response to debt deviations: deficit = trend structural deficit − 휞2 ⋅ (debt deviation) + shock.
  - Debt target steady state: 품풃 ̅ 풕 신 steady-state = 60 percent.
  - Debt deviation incorporates forward-looking expectations of future deviations.
  - Fiscal response coefficient 휞2 governs consolidation speed; calibrated to reflect the proposed 60 percent ceiling.
- Deficit decomposition:
  - Total deficit (as share of GDP) = structural primary deficit + interest payments + residual shock.
- Debt accumulation identity:
  - 품풃 풕 = 풅풆풇 풕 + 품풃 풕−1 / (1 + 휟풏풚 풕 / 400) + stock-flow adjustment shock.
- Sovereign premium reacts to debt deviations via coefficient 풃7, feeding into effective government borrowing rates.

### Core model equations and key mechanisms (select highlights)
- IS curve (output gap dynamics):
  - 풚̂ 풕 = 풃1 풚̂ 풕−1 + 풃2 풎풄풊 풕 + 풃3 풚̂ 풕 ∗ + FISC_IMP 풕 + ε 풕 풚
  - Lagged gap persistence parameter 풃1 = 0.5.
- Monetary conditions index:
  - 풎풄풊 풕 = 풃4*(풓̂ 풕 + CR_PREM 풕 + 풃6 * rho_b_dev 풕) + (1−풃4)*(−풛̂ 풕)
  - Weight of real interest rate gap in monetary conditions index 풃4 = 0.7.
- Inflation decomposition:
  - Three Phillips curves for food (F), energy (E), and core (XFE).
  - Backward-looking inflation persistence parameters:
    - 풂1,퐅 = 0.25 (food)
    - 풂1,퐄 = 0.25 (energy)
    - 풂1,푿푭푬 = 0.5 (core)
- Exchange rate:
  - Modified UIP: 풍 풔 풕 = 풍 풔 풕+1 e + i_t^* − i_t + prem_t^s + ε_s,t
  - Adaptive expectation weight 풆1 = 0.2.
- Monetary policy rule:
  - 풊 풕 = 품1 풊 풕−1 + (1−품1)(풊 풕^n + 품2(E_t{흅_t+3} − 흅_t+3^T) + 품3 풚̂ 풕) + ε_i,t
  - Smoothing 품1 = 0.8; inflation reaction coefficient 품2 ≈ 0.15 (empirical discussion cites an estimate around 1.15 for Korea’s practical response); output weight 품3 = 0.15.
- Inflation target steady state: 흅_SS = 2 percent.

### Fiscal impulse and transmission
- Fiscal impulse definition:
  - FISC_IMP_t = c1_fi * FISC_IMP_{t-1} + c2_fi * FISC_IMP_{t-2} + c3_fi*(def_str_ann_t − def_str_ann_{t-1} + ε_def_t)
- Fiscal rule trade-offs:
  - A debt-stabilizing fiscal rule can generate short-run procyclicality when shocks temporarily reduce nominal GDP: fiscal adjustments to debt deviations can amplify cyclical fluctuations.
  - Without a fiscal rule, debt-to-GDP tends to drift after shocks because temporary nominal GDP movements translate into persistent debt ratio changes.
- Policy relevance:
  - Temporary fiscal expansions followed by subsequent adjustment yield manageable debt changes.
  - Persistent fiscal expansions without offsets produce debt dynamics that eventually require correction.

### Model validation and historical interpretation
- Validation methods:
  - Historical (equation-based) decompositions to attribute past developments to model drivers.
  - Out-of-sample forecast evaluation for GDP growth and inflation at policy-relevant horizons.
- Key historical findings:
  - Core inflation drivers: persistence, exchange rate movements, and domestic demand.
    - Backward-looking persistence parameter for core 흅: 풂1,푿푭푬 = 0.5 implies roughly half of current core inflation reflects past inflation.
  - Food and energy inflation dominated by external factors:
    - World commodity prices and exchange rate movements account for approximately 75 percent of food inflation variation and 100 percent of energy inflation variation.
    - World food prices pushed Korean food inflation to around 7 percent year-on-year in mid-2022.
    - World oil prices drove energy inflation above 20 percent year-on-year in early 2022.
  - Output gap dynamics:
    - External demand is a prominent driver due to Korea’s export orientation.
    - The COVID-19 pandemic induced an output gap contraction to approximately −1.8 percent in 2020Q2.
    - Fiscal policy provided substantial offsetting support during 2020-2021 via positive fiscal impulses.

### Calibration highlights and key parameter values (selected)
- IS curve persistence 풃1 = 0.5.
- Monetary conditions index weights:
  - 풃2 = −0.2; 풃3 = 0.2; 풃4 = 0.7; 풃5 = 0.7.
- Exchange rate persistence 품 = 0.2 (풆1 = 0.2).
- Phillips curve parameters:
  - Food: 풂1,퐅 = 0.25; 풂2,퐅 = 0.1; 풂3,퐅 = 0.25.
  - Energy: 풂1,퐄 = 0.25; 풂2,퐄 = 0.05; 풂3,퐄 = 0.
  - Core (XFE): 풂1,푿푭푬 = 0.5; 풂2,푿푭푬 = 0.25; 풂3,푿푭푬 = 0.85.
- Monetary policy rule:
  - Smoothing 품1 = 0.8; inflation reaction 품2 = 0.15; output weight 품3 = 0.15.
- Fiscal block:
  - Debt deviation reaction 휞2 = 0.15.
  - Weight of current debt deviation in effective debt gap 흆 품풃_풅풆풗 = 0.5.
  - Debt target steady-state 품풃 ̅_SS = 60 percent.

### Historical decomposition and recent recovery (select quantitative notes)
- Growth recovered by "1.2 percent on average."
- By "2023-2024":
  - policy normalization began restraining demand.
  - RIR gap contributions diminished.
  - fiscal impulse turned neutral to slightly negative.
- Pandemic response in "2020":
  - Bank of Korea cut policy rates by "75 basis points" cumulatively.
  - MCI shows policy stance remained restrictive in the first half of "2020" as the RIR gap stayed positive.
- Policy tightening in 2022-2023:
  - The policy rate increased by 275 basis points cumulatively during 2022-2023.

### Forecast evaluation (methodology and performance)
- Pseudo out-of-sample forecasting starting from 2015Q1 with six-quarter-ahead forecasts; external variables conditioned on actual data for U.S. GDP, inflation, and interest rates, world oil and food prices, government debt and deficit, and trends estimated using full-sample filter up to end-2025.
- Forecast accuracy measured by RMSE and relative RMSE versus a random walk benchmark.
- Performance summary:
  - GDP growth and output gap: model substantially outperforms the random walk benchmark across horizons.
  - Inflation: core inflation forecasts perform well; food and energy inflation forecasts less accurate due to commodity volatility.
  - Interest rates and exchange rates: random walk outperforms model at short horizons for interest rates; model improves over longer horizons. Exchange rate forecasts moderately outperform random walk.

### Simulations and scenario analysis: setup
- Two fiscal policy regimes compared:
  - Regime A: debt-stabilizing fiscal rule (responds to debt deviations).
  - Regime B: constant primary deficit (no systematic fiscal anchor).
- Five shock scenarios:
  - monetary policy tightening (temporary 100 basis point increase above the Taylor rule);
  - fiscal expansion (1 percentage point increase in the primary deficit; temporary versus persistent);
  - disinflationary supply shock (negative 1pp shock to core inflation);
  - exchange rate appreciation (negative 1pp shock to the UIP equation);
  - demand expansion (1pp shock to the IS curve).
- Simulation legend: blue lines = debt-stabilizing rule; orange lines = no systematic fiscal response.

### Simulations and scenario analysis: key stylized findings
- Monetary policy shock (temporary 100 basis points):
  - Rate increase contracts demand and inflation; nominal GDP falls mechanically raising debt-to-GDP.
  - With debt-stabilizing rule: fiscal tightening amplifies contraction; monetary easing must be larger and more prolonged; fiscal response is procyclical.
  - Without fiscal rule: faster adjustment but debt rises permanently.
- Fiscal shock (1 percentage point increase in primary deficit):
  - Temporary expansion: raises output gap and inflation; monetary policy tightens; fiscal impulse fades as rule requires consolidation; debt returns to target.
  - Persistent expansion: debt grows continuously; initial demand effects similar but debt rises without bound and markets would eventually demand higher risk premia.
- Supply shock (negative 1pp to core inflation):
  - Reduces inflation and nominal GDP; debt-to-GDP mechanically rises.
  - With debt-stabilizing rule: fiscal tightening amplifies output decline; monetary policy eases more aggressively; medium-term debt stability restored.
  - Without rule: smoother short-run adjustment but permanent debt drift.
- Exchange rate appreciation (negative 1pp to UIP):
  - Appreciation reduces import prices and external demand; disinflation and nominal GDP slowdown raise debt-to-GDP.
  - With debt-stabilizing rule: fiscal tightening amplifies contraction; monetary easing required; debt returns to target as nominal GDP recovers.
  - Without rule: debt-to-GDP rises persistently.
- Demand shock (1pp to IS curve):
  - Real GDP and inflation rise; nominal GDP increases reduce debt-to-GDP.
  - With debt-stabilizing rule: fiscal expansion reinforces demand; monetary policy tightens more aggressively; amplification is temporary and debt returns to target.
  - Without rule: monetary policy alone manages stabilization with smaller initial fiscal amplification.

### Overall policy implications and trade-offs
- Fiscal anchors (debt-stabilizing rules targeting 60 percent debt-to-GDP and a 3 percent deficit ceiling) prevent permanent debt drift but can amplify short-run macro volatility, especially for nominal shocks (monetary tightening, supply disinflation, exchange rate appreciation).
- The speed and design of fiscal adjustment under rules affect the magnitude of procyclical amplification.
- For real (demand) shocks, fiscal rules produce less harmful amplification and help ensure debt stability.
- Model limitations: omission of potential supply-side gains from productive spending and short-term forecast errors for inflation and interest rates suggest results should be interpreted alongside institutional and market information.
- For Korea:
  - Near-term fiscal space exists, but structural fiscal pressures from population aging and rising age-related spending are likely to intensify in coming years.
  - A medium-term fiscal anchor can limit debt drift from repeated shocks but can also introduce short-run procyclicality and constrain flexibility to accommodate structural spending.

### Conclusion (summary)
- The QPM with an integrated fiscal block captures Korea’s macro dynamics and clarifies trade-offs in fiscal rule design:
  - Fiscal rules secure medium-term debt stability but may amplify short-run volatility when shocks affect nominal GDP.
  - Absence of fiscal rules yields smoother short-run macro responses but permits persistent debt-to-GDP drift from temporary nominal shocks.
- Policy choice for authorities: weigh these costs and benefits against existing medium-term budget framework discipline.

*Source: IMF Working Paper — Introduction section of "Monetary–Fiscal Policy Interactions in Korea: A QPM-Based Analysis" (wpiea2026172-source-pdf).*

### Introduction ...........................................................................................................

### Introduction

### Major Sections
- Introduction (page 3)
- The Model (page 5)
  - The Core Model (page 5)
  - The Fiscal Block (page 10)
- Calibration (page 14)
- Model Validation (page 14)
- Historical Data Interpretation (page 15)
- Evaluation of Forecast Accuracy (page 19)
- Simulations and Scenario Analysis (page 24)
  - Monetary Policy Shock (page 24)
  - Fiscal Shock: Transitory versus Persistent Expansion (page 25)
  - Supply Shock (page 26)
  - Exchange Rate Shock (page 28)
  - Demand Shock (page 29)
- Conclusion (page 30)
- References (page 31)

### Figures (listed)
- Figure 1. Core Inflation Decomposition (YoY)
- Figure 2. Food and Energy Inflation Decompositions
- Figure 3. Output Gap Decomposition
- Figure 4. Monetary Conditions Index & Policy Rate Decomposition
- Figure 5. Real GDP Growth and Output Gap
- Figure 6. Inflation
- Figure 7. Interest Rate and Exchange Rate
- Figure 8. Monetary Policy Shock
- Figure 9. Fiscal Shock
- Figure 10. Supply Shock
- Figure 11. Exchange Rate Shock
- Figure 12. Demand Shock

### Tables (listed)
- Table 1. Calibration Parameters of Key Behavioral Equations

### Document identification
- IMF WORKING PAPERS Monetary–Fiscal Policy Interactions in Korea: A QPM-Based Analysis
- INTERNATIONAL MONETARY FUND (page 3)

*Source: wpiea2026172-source-pdf - Introduction (canonical PDF: https://www.imf.org/-/media/files/publications/wp/2026/english/wpiea2026172-source-pdf.pdf).*

### Introduction

### Introduction

### Korea’s fiscal and monetary challenges
- Korea faces evolving fiscal challenges driven by rapid population aging (among the fastest in the OECD) and moderating potential growth, raising concerns about long-term fiscal sustainability.
- A proposed fiscal framework (under consideration since 2021-22) would target:
  - government debt-to-GDP ratio ceiling of 60 percent; and
  - a fiscal deficit cap of 3 percent of GDP.
- The Bank of Korea operates with a 2 percent inflation target.
- Recent episodes (COVID-19 support, policy-rate reductions, and the 2021-2022 inflation surge) highlighted interaction issues between fiscal support and monetary tightening.

### Objectives and contributions of the paper
- Develops a Quarterly Projection Model (QPM) for Korea with an integrated fiscal block to analyze monetary–fiscal interactions.
- Extends standard QPMs (New Keynesian semi-structural “gap” models) by incorporating:
  - separate inflation dynamics for core, food, and energy components;
  - exchange rate dynamics via a modified uncovered interest parity with a country risk premium; and
  - a fiscal block with stock-flow consistency and an endogenous debt-stabilizing fiscal rule.
- Enables analysis of how a medium-term fiscal anchor (e.g., a 60 percent debt ceiling) affects macro stability and debt sustainability.

### Theoretical framework and modeling approach
- QPM structure:
  - Focus on gaps (deviations from long-run equilibrium) for output, inflation, interest rates, and exchange rates.
  - Monetary policy represented by a reaction function responding to inflation deviations and the output gap (forward-looking Taylor rule with smoothing).
  - Fiscal block captures primary deficits, interest payments, debt accumulation, and a fiscal rule responding to debt deviations.
- Fiscal impulse enters the IS curve as a reduced-form demand effect; debt dynamics and fiscal credibility feed back into financial conditions via an expected-debt term.

### Fiscal policy design in the model
- Fiscal rule specification:
  - Structural primary deficit adjusts in response to debt deviations from target: deficit = trend structural deficit − 휞2 ⋅ (debt deviation) + shock.
  - Debt target steady state: 품풃 ̅ 풕 신 steady-state = 60 percent.
  - Debt deviation incorporates forward-looking expectations of future deviations.
  - The fiscal response coefficient 휞2 governs consolidation speed; calibrated to reflect the proposed 60 percent ceiling.
- Deficit decomposition:
  - Total deficit (as share of GDP) = structural primary deficit + interest payments + residual shock.
- Debt accumulation:
  - Debt-to-GDP evolves via the identity: 품풃 풕 = 풅풆풇 풕 + 품풃 풕−1 / (1 + 휟풏풚 풕 / 400) + stock-flow adjustment shock.
- Sovereign premium reacts to debt deviations via coefficient 풃7, feeding into effective government borrowing rates.

### Core model equations and key mechanisms (select highlights)
- IS curve (output gap dynamics):
  - 풚̂ 풕 = 풃1 풚̂ 풕−1 + 풃2 풎풄풊 풕 + 풃3 풚̂ 풕 ∗ + FISC_IMP 풕 + ε 풕 풚
  - Lagged gap persistence parameter 풃1 = 0.5.
- Monetary conditions index:
  - 풎풄풊 풕 = 풃4*(풓̂ 풕 + CR_PREM 풕 + 풃6 * rho_b_dev 풕) + (1−풃4)*(−풛̂ 풕)
  - Weight of real interest rate gap in monetary conditions index 풃4 = 0.7.
- Inflation decomposition:
  - Three Phillips curves for food (F), energy (E), and core (XFE).
  - Backward-looking inflation persistence parameters:
    - 풂1,퐅 = 0.25 (food)
    - 풂1,퐄 = 0.25 (energy)
    - 풂1,푿푭푬 = 0.5 (core)
- Exchange rate:
  - Modified UIP: 풍 풔 풕 = 풍 풔 풕+1 e + i_t^* − i_t + prem_t^s + ε_s,t
  - Adaptive expectation weight 풆1 = 0.2.
- Monetary policy rule:
  - 풊 풕 = 품1 풊 풕−1 + (1−품1)(풊 풕^n + 품2(E_t{흅_t+3} − 흅_t+3^T) + 품3 풚̂ 풕) + ε_i,t
  - Smoothing 품1 = 0.8; inflation reaction coefficient 품2 ≈ 0.15 (model discussion cites an empirical estimate around 1.15 for Korea’s practical response); output weight 품3 = 0.15.
- Inflation target steady state: 흅_SS = 2 percent.

### Fiscal impulse and transmission
- Fiscal impulse definition:
  - Smoothed changes in annual primary deficit-to-GDP mapped to GDP growth with inertia:
    - FISC_IMP_t = c1_fi * FISC_IMP_{t-1} + c2_fi * FISC_IMP_{t-2} + c3_fi*(def_str_ann_t − def_str_ann_{t-1} + ε_def_t)
- Fiscal rule trade-offs:
  - A debt-stabilizing fiscal rule can generate short-run procyclicality when shocks temporarily reduce nominal GDP: fiscal adjustments to debt deviations can amplify cyclical fluctuations.
  - Without a fiscal rule, debt-to-GDP tends to drift after shocks because temporary nominal GDP movements translate into persistent debt ratio changes.
- Policy relevance:
  - Temporary fiscal expansions followed by subsequent adjustment yield manageable debt changes.
  - Persistent fiscal expansions without offsets produce debt dynamics that eventually require correction.

### Model validation and historical interpretation
- Validation methods:
  - Historical (equation-based) decompositions to attribute past developments to model drivers.
  - Out-of-sample forecast evaluation for GDP growth and inflation at policy-relevant horizons.
- Key historical findings:
  - Core inflation drivers: persistence, exchange rate movements, and domestic demand.
    - Backward-looking persistence parameter for core 흅: 풂1,푿푭푬 = 0.5 implies roughly half of current core inflation reflects past inflation.
  - Food and energy inflation dominated by external factors:
    - World commodity prices and exchange rate movements account for approximately 75 percent of food inflation variation and 100 percent of energy inflation variation.
    - World food prices pushed Korean food inflation to around 7 percent year-on-year in mid-2022.
    - World oil prices drove energy inflation above 20 percent year-on-year in early 2022.
  - Output gap dynamics:
    - External demand is a prominent driver due to Korea’s export orientation.
    - The COVID-19 pandemic induced an output gap contraction to approximately −1.8 percent in 2020Q2.
    - Fiscal policy provided substantial offsetting support during 2020-2021 via positive fiscal impulses.

### Scenario analysis (summary of approach and stylized results)
- Two fiscal regimes compared:
  - Regime A: debt-stabilizing fiscal rule (responds to debt deviations).
  - Regime B: constant primary deficit (no systematic fiscal anchor).
- Five shock scenarios analyzed:
  - A disinflationary supply shock.
  - An exchange rate appreciation.
  - A demand expansion.
  - A monetary policy adjustment.
  - A fiscal expansion (compared as temporary versus persistent).
- Stylized observations:
  - Fiscal rules can induce short-run procyclicality when shocks affect nominal GDP, potentially amplifying the shock and altering monetary policy responses.
  - Absence of fiscal rules leads to debt drift following shocks, converting temporary nominal GDP changes into lasting debt-to-GDP ratio shifts.
  - Korea’s demographic trends imply rising age-related spending over the medium term; the pace and magnitude of fiscal-space erosion depend on growth, revenue, and expenditure-reform measures.

### Calibration highlights and key parameter values (selected)
- IS curve persistence 풃1 = 0.5.
- Monetary conditions index weights:
  - 풃2 = −0.2; 풃3 = 0.2; 풃4 = 0.7; 풃5 = 0.7.
- Exchange rate persistence 품 = 0.2 (풆1 = 0.2).
- Phillips curve parameters:
  - Food: 풂1,퐅 = 0.25; 풂2,퐅 = 0.1; 풂3,퐅 = 0.25.
  - Energy: 풂1,퐄 = 0.25; 풂2,퐄 = 0.05; 풂3,퐄 = 0.
  - Core (XFE): 풂1,푿푭푬 = 0.5; 풂2,푿푭푬 = 0.25; 풂3,푿푭푬 = 0.85.
- Monetary policy rule:
  - Smoothing 품1 = 0.8; inflation reaction 품2 = 0.15; output weight 품3 = 0.15.
- Fiscal block:
  - Debt deviation reaction 휞2 = 0.15.
  - Weight of current debt deviation in effective debt gap 흆 품풃_풅풆풗 = 0.5.
  - Debt target steady-state 품풃 ̅_SS = 60 percent.

### Organization of the paper (outline)
- Section II: model structure and behavioral equations.
- Section III: model calibration and parameter choices.
- Section IV: model validation (historical decompositions and forecast evaluation).
- Section V: scenario analysis comparing dynamics with and without fiscal rules.
- Section VI: conclusions and observations relevant to Korea’s fiscal policy framework discussion.

*IMF Working Paper — Introduction section of "Monetary–Fiscal Policy Interactions in Korea: A QPM-Based Analysis."*

### 1.2 percent on average. This recovery was supported by multiple factors: accommodative monetary conditions

### wpiea2026172-source-pdf - 1.2 percent on average. This recovery was supported by multiple factors: accommodative monetary conditions

### Recovery overview and driving factors
- Growth recovered by "1.2 percent on average."
- Recovery supported by multiple factors:
  - accommodative monetary conditions (positive dark blue RIR gap contributions)
  - recovering external demand (purple bars turning positive)
  - continued fiscal support (positive green bars)
- By "2023-2024":
  - policy normalization began restraining demand
  - RIR gap contributions diminished
  - fiscal impulse turned neutral to slightly negative (green bars near zero)
  - external demand remained supportive
- Decomposition aligns with Korea's recent economic performance:
  - external demand-driven contraction in "2020"
  - strong policy-supported recovery in "2021-2022"
  - gradual normalization in "2023-2024"

### Monetary Policy Stance (decomposition insights)
- Monetary conditions index (MCI) combines interest rate and exchange rate effects; positive values indicate restrictive conditions.
- Policy rate decomposed into Taylor rule components:
  - lagged rate (smoothing)
  - neutral rate adjusted for expected inflation
  - inflation deviations from target
  - output gap
  - policy shocks reflecting deviations from systematic behavior
- "2020" pandemic response:
  - Bank of Korea cut policy rates by "75 basis points" cumulatively
  - MCI shows policy stance remained restrictive in the first half of "2020" as the RIR gap (blue bars) stayed positive
  - Real interest rates initially increased because inflation expectations fell faster than nominal rates, keeping monetary conditions tight in the short run
  - By the end of "2020" this was reversed as inflation expectations fully adjusted
- "2021-2022":
  - actual rates remained slightly below what the Taylor rule prescribed, visible as negative green policy shock bars
  - model interprets persistent accommodation as deliberate support for economic recovery, with the central bank prioritizing output stabilization over strict adherence to the systematic rule

### Exchange rate contributions to monetary conditions
- Exchange rate movements played a significant role in post-pandemic monetary conditions.
- MCI decomposition shows large negative contributions from the RER gap (yellow bars) during "2021-2022", indicating won depreciation substantially loosened monetary conditions.
- This exchange rate effect helped maintain an accommodative overall stance even as the Bank of Korea began raising rates.

*Source: https://www.imf.org/-/media/files/publications/wp/2026/english/wpiea2026172-source-pdf.pdf*

### 2022. The policy rate increased by 275 basis points cumulatively during 2022-2023, visible in the right panel as

### wpiea2026172-source-pdf - 2022. The policy rate increased by 275 basis points cumulatively during 2022-2023, visible in the right panel as

### Monetary Conditions and Policy Rate Decomposition
- The policy rate increased by 275 basis points cumulatively during 2022-2023 (black line rising sharply).
- The Monetary Conditions Index (MCI) shows more gradual tightening than interest rates alone due to exchange rate depreciation (negative yellow bars) partially offsetting the restrictive impact of higher policy rates.
- By 2023-2024, monetary conditions normalized as both interest rates stabilized and exchange rate effects diminished.
- For a small open economy like Korea, the exchange rate channel is an important component of the monetary transmission mechanism and can reinforce or offset interest rate policy.

### Forecast Evaluation Methodology
- Forecast performance assessed via pseudo out-of-sample forecasting (sequentially withholding historical data and generating forecasts).
- Key difference: recursive forecasts condition on trends and external variables derived from the full-sample filter outcome to isolate behavioral equations' forecasting performance.
- Starting from 2015Q1, six-quarter-ahead forecasts are generated conditioning on actual data for:
  - external variables: U.S. GDP, inflation, and interest rates;
  - commodity prices: world oil and food prices;
  - fiscal variables: government debt and deficit;
  - trends estimated using the full set of historical data up to the end of 2025: potential output, neutral interest rate, equilibrium exchange rate, relative price trends.
- Forecast sequence created by adding one quarter of actual data and repeating through 2024Q4.
- Forecast accuracy measured using Root Mean Squared Error (RMSE) and relative RMSE versus a naive random walk benchmark:
  - If relative RMSE is less than one, the model outperforms the naïve benchmark; greater than one indicates the opposite.
- Note: a more rigorous evaluation conditioning on recursively estimated trends and judgmental/external assumptions would require a database of real-time forecasts not yet available.

### Forecast Performance: GDP Growth and Output Gap
- The model demonstrates strong forecasting performance for GDP growth and the output gap.
- Actual series closely track predicted paths; the model anticipated:
  - the pandemic-induced contraction in 2020,
  - the sharp recovery in 2021,
  - subsequent moderation in 2022-2024.
- Forecast errors are smallest during stable periods and largest during the initial pandemic shock.
- The model significantly outperforms the random walk benchmark across all forecast horizons for GDP, reflecting the value of conditioning on external drivers and fiscal variables.

### Forecast Performance: Inflation
- Inflation forecasting performance varies by component and horizon.
- Core inflation forecasts perform well across all horizons due to closer links to modeled drivers (output gap, exchange rate).
- Food and energy inflation forecasts are less accurate because of high volatility and sensitivity to commodity price shocks.
- Quantitative measures show the model consistently delivers forecast accuracy improvements over longer horizons (three to six quarters).

### Forecast Performance: Interest Rates and Exchange Rates
- Interest rate forecasts: random walk outperforms the model at shorter horizons; model improves over longer, policy-relevant horizons.
  - Much deviation occurred during 2020-2022 when the central bank prioritized economic support over strict adherence to systematic rules.
- Exchange rate forecasts moderately outperform the random walk, consistent with a modified uncovered interest parity condition providing structure for medium-term movements.
- Summary assessment:
  - GDP forecasts substantially outperform naive benchmarks.
  - Inflation forecasts reasonable, especially core inflation at medium horizons.
  - Interest rate forecasts improve at policy-relevant horizons.
  - Exchange rates show moderate predictability.
  - Recognized limitations: short-term inflation and interest rate forecast errors; mechanical forecasts should be combined with institutional knowledge and market information.

### Simulations and Scenario Analysis: Setup
- Two fiscal policy regimes compared:
  - Debt-stabilizing fiscal rule: fiscal authority adjusts the primary deficit in response to deviations of debt from its target. This resembles Korea's proposed framework targeting a 60 percent debt-to-GDP ratio with a 3 percent deficit ceiling.
  - Constant primary deficit: no systematic fiscal anchor.
- Five shock scenarios analyzed: monetary policy tightening, fiscal expansion, disinflationary supply shock, exchange rate appreciation, and demand expansion.
- In simulation charts:
  - Blue lines: dynamics with the debt-stabilizing rule.
  - Orange lines: dynamics without systematic fiscal response.

### Simulations and Scenario Analysis: Key Findings by Shock

- Monetary Policy Shock
  - Shock modeled as a temporary 100 basis point increase in the policy rate above the Taylor rule prescription.
  - Effects:
    - Rate increase contracts demand, reducing output and inflation.
    - Lower nominal GDP mechanically raises the debt-to-GDP ratio.
  - With a debt-stabilizing rule:
    - Fiscal tightening required to return debt to target; this amplifies contractionary impulse (output gap declines further, inflation falls more).
    - Monetary easing required to restore equilibrium must be larger and more prolonged.
    - Fiscal response is procyclical and amplifies macroeconomic costs.
  - Without a fiscal rule:
    - Monetary policy can reverse temporary deviation without fiscal amplification.
    - Adjustment is faster and less volatile, but debt rises permanently due to the temporary nominal GDP decline.
  - Trade-off: fiscal rules prevent permanent debt drift but may amplify temporary macro volatility; speed of adjustment matters.

- Fiscal Shock: Transitory versus Persistent Expansion
  - Shock modeled as an exogenous 1 percentage point increase in the primary deficit.
  - Temporary expansion (blue line):
    - Stimulates demand, raises output gap and inflation.
    - Monetary policy tightens; fiscal impulse fades as rule requires consolidation; debt returns to target.
  - Persistent expansion (orange line):
    - Higher deficit continues indefinitely; debt grows continuously.
    - Initial demand and inflation effects similar, but without consolidation debt rises without bound.
    - Persistent scenario is not an equilibrium; markets would eventually demand higher risk premia.
  - Caution: model abstracts from potential supply-side gains from productive public spending (R&D, infrastructure, demographic transition) that could enhance potential output.

- Supply Shock (Disinflationary)
  - Modeled as a negative cost-push disturbance (negative 1pp shock to core inflation).
  - Effects:
    - Reduces inflation and nominal GDP, mechanically raising the debt-to-GDP ratio.
  - With a debt-stabilizing rule:
    - Fiscal tightening amplifies disinflationary impulse; output gap declines further.
    - Monetary policy must ease more aggressively (cut rates deeper and for longer).
    - Short-run volatility increases but delivers medium-term stability; once nominal GDP recovers, fiscal rule allows deficits to rise and debt returns to target.
  - Without a fiscal rule:
    - Adjustment smoother in short run; monetary policy alone manages stabilization.
    - Price level remains permanently lower; nominal GDP settles at a lower level; debt-to-GDP ratio rises permanently.
  - Trade-off: fiscal rules generate short-run volatility but ensure debt returns to target; absence of rules yields smoother stabilization but permanent debt drift.

- Exchange Rate Shock (Appreciation)
  - Modeled as an exogenous strengthening of the won (negative 1pp shock to the UIP equation).
  - Effects:
    - Appreciation reduces import prices, causing disinflation and weakening external demand for exports; nominal GDP growth falls and debt-to-GDP rises.
  - With a debt-stabilizing rule:
    - Fiscal tightening amplifies demand contraction; monetary easing required; short-run volatility rises but debt returns to target as nominal GDP recovers.
  - Without a fiscal rule:
    - Debt-to-GDP ratio rises persistently as lower nominal GDP raises the ratio without fiscal adjustment.
  - Note: If a substantial share of government debt is foreign-currency denominated, appreciation can reduce the won value of that debt; for Korea, most government debt is won-denominated so this automatic stabilizer is limited.
  - Implication: in an open, export-oriented economy like Korea, repeated external shocks without fiscal anchors pose risks of permanent debt drift.

- Demand Shock
  - Modeled as an exogenous 1pp increase in the output gap (1pp shock to the IS curve).
  - Effects:
    - Real GDP and inflation rise; nominal GDP increases, reducing debt-to-GDP.
  - With a debt-stabilizing rule:
    - Fiscal rule prescribes expansion to return debt to target, reinforcing demand impulse; monetary policy tightens more aggressively.
    - Amplification is temporary; debt gradually returns to target.
  - Without a fiscal rule:
    - Initial demand impact smaller; monetary policy manages stabilization alone.
  - For real shocks, the fiscal rule's short-run amplification is less concerning because fiscal and monetary policies act in the same direction; for Korea, fiscal rule's debt-stabilizing role outweighs modest additional volatility during expansions.

### Overall Policy Implications and Trade-offs
- Fiscal anchors (debt-stabilizing rules targeting 60 percent debt-to-GDP and a 3 percent deficit ceiling) prevent permanent debt drift but can amplify short-run macroeconomic volatility, especially for nominal shocks (monetary tightening, supply disinflation, exchange rate appreciation).
- The speed and design of fiscal adjustment under rules affect the magnitude of procyclical amplification.
- For real (demand) shocks, fiscal rules produce less harmful amplification and help ensure debt stability.
- Model limitations: omission of possible supply-side benefits from productive spending and short-term forecast errors for inflation and interest rates imply results should be interpreted with nuance and complemented by institutional and market information.

*IMF WORKING PAPERS Monetary–Fiscal Policy Interactions in Korea: A QPM-Based Analysis*

### Conclusion

### Conclusion

### Model and validation
- Developed a quarterly projection model for Korea with an integrated fiscal block to analyze monetary-fiscal policy interactions.
- Model features:
  - Government debt dynamics.
  - Fiscal policy rules that adjust deficits in response to debt deviations from target.
- Validation exercises show the model captures Korea's macroeconomic dynamics reasonably well.

### Scenario analysis and key findings
- Comparison of dynamics with and without debt-stabilizing fiscal rules reveals a fundamental trade-off:
  - With fiscal rules:
    - Fiscal rules generate short-run procyclicality when shocks affect nominal GDP.
    - This procyclicality requires more aggressive monetary responses and creates temporary volatility.
  - Without fiscal rules:
    - Debt drifts permanently as temporary nominal GDP movements translate into lasting debt-to-GDP changes.
- For Korea:
  - There is near-term fiscal space.
  - Structural fiscal pressures from population aging and rising age-related spending are likely to intensify in the coming years.
- The analysis illustrates:
  - A medium-term anchor can limit debt drift from repeated shocks.
  - As the simulations show, a medium-term anchor can also introduce short-run procyclicality and constrain the flexibility needed to accommodate structural spending.

### Policy considerations
- The appropriate framework is a policy choice for the authorities, weighing these costs and benefits against the discipline already provided by Korea's existing medium-term budget framework.

*Monetary–Fiscal Policy Interactions in Korea: A QPM-Based Analysis Working Paper No. WP/2026/172*

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_Source: https://www.imf.org/-/media/files/publications/wp/2026/english/wpiea2026172-source-pdf.pdf_