KDI "In High Debt Situations, Raising Base Interest Rate Causes GDP to Drop Twice as Much"

[Sejong=Asia Economy Reporter Son Seonhee] An analysis has emerged that raising the base interest rate during a high debt phase has twice the negative impact on economic growth compared to normal times. It also suggested that since the Korean economy has not yet entered a solid recovery phase, the side effects of interest rate hikes on the economy should be considered together.

The Korea Development Institute (KDI) stated in its April 4 report titled "Macroeconomic Effects of Interest Rate Hikes by Private Debt Phase" that "interest rate hikes during a high debt phase have a greater impact on the economy than usual, reducing inflation and debt growth rates."

The report analyzed the relationships among variables such as real Gross Domestic Product (GDP), consumer prices, base interest rate (call rate), and private debt from the second quarter of 1999 to the first quarter of 2021 to examine the effects of monetary policy on the economy and inflation during the phase of rapidly expanding debt following the COVID-19 crisis.

As a result, Cheon Sora, head of the Economic Outlook Office and model coordinator, explained, "Raising the base interest rate by 25 basis points during a high debt phase results in a maximum 0.15 percentage point decline in economic growth, which is about twice the negative impact compared to the low debt phase (-0.08 percentage points)." However, she added, "The decreases in inflation and debt growth rates due to the interest rate hike were minimal, and no statistical significance was found."

She also said, "The response of the debt growth rate to the interest rate hike was not significant, suggesting that controlling the debt growth trend in the short term by interest rate hikes alone has limitations."

Cheon further stated, "Since private debt has been rapidly increasing recently, policy responses are required to reduce the possibility of financial instability," adding, "While interest rate hikes may partially alleviate financial market instability, it is necessary to decide the pace of monetary policy normalization considering that it may simultaneously hinder economic recovery." She also emphasized, "It is necessary to utilize a policy mix of monetary policy and macroprudential policies to strengthen financial stability."

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