Equities drive the currency: Evolving dynamics of Korea's financial system

Abstract

This study investigates the evolving dynamic relationships between exchange rates, price level, interest rates, and the Korea Composite Stock Price Index (KOSPI) in the context of Korea's rapidly transforming economy from January 1982 to February 2025. Employing a comprehensive empirical framework that integrates cointegration analysis, vector autoregression‐based methods, specifically the Vector Error Correction Model (VECM), and time‐varying Granger causality techniques, the research captures both long‐run equilibrium relationships and short‐term feedback effects while also accommodating structural breaks and regime shifts. The analysis reveals four cointegrating vectors, indicating deep systemic interdependence, and highlights the potential role of the KOSPI in driving exchange rate movements, particularly in the post‐2008 era of increased foreign and retail investor participation. The price level remains relatively stable under Korea's inflation‐targeting regime, with limited short‐term spillovers from interest rates, reflecting a unique policy landscape shaped by high household debt and macroprudential interventions. Time‐varying causality tests uncover shifting transmission mechanisms, with equity and price level shocks exerting episodic but significant influence on exchange rates. The findings underscore the need for adaptive policy frameworks that balance exchange rate management, monetary autonomy, and financial stability in an era of fintech innovation and heightened market volatility. Potential policy implications include considerations for foreign exchange interventions, safeguards for retail‐dominated equity sectors, and the evolving role of digital finance in shaping price level dynamics and macroeconomic stability.