Conducting monetary policy in a global economy

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Pengarang: Parry, Robert T.

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Info publikasi: Business Economics 33. 4 (Oct 1998): 14-19.

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Abstrak: Three factors are examined that determine the extent to which a domestic economy is vulnerable to foreign shocks: 1. the degree of integration of financial and goods markets, 2. the relative size of the economy, and 3. the choice of exchange rate regimes. The choice of exchange rate regimes also affects the independence of a country's monetary policy; in principle, when capital is freely mobile, a country cannot simultaneously fix its exchange rate and control its domestic interest rate. This principle has become known as the unholy trinity of international economics, and its ramifications are explored for the conduct of monetary policy under flexible and fixed exchange rate regimes. It is concluded that greater integration of financial and goods markets has increasingly subjected domestic economies to the effects of changes in economic conditions abroad and has importantly affected the monetary policy transmission mechanism.
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Teks Lengkap: Headnote By Robert T. Parry* Headnote This article begins by examining the three factors that determine the extent to which a domestic economy is vulnerable to foreign shocks: the degree of integration of financial and goods markets, the relative size of the economy, and the choice of exchange rate regimes. The choice of exchange rate regimes also affects the independence of a country's monetary policy; in principle, when capital is freely mobile, a country cannot simultaneously fix its exchange rate and control its domestic interest rate. This principle has become known as the "unholy trinity" of international economics, and its ramifications are explored for the conduct of monetary policy under flexible and fixed exchange rate regimes. The article concludes that greater integration of financial and goods markets has increasingly subjected domestic economies to the effects of changes in economic conditions abroad and has importantly affected the monetary policy transmission mechanism. However, these developments do not imply that domestic monetary policy is necessarily less effective in the United States and other countries that allow their currencies to float. IN THE PAST THIRTY YEARS the global economy has undergone tremendous change and become increasingly more integrated. World trade has grown much faster than world output, and international capital flows have expanded still more rapidly. The increased integration of international markets for goods and services is attributable to a steady liberalization of trade barriers since World War II, falling costs of transportation, and the spread of production technology across national boundaries. As a result of these developments, households and businesses in all countries have come to depend increasingly on foreign sources of supply for consumption goods and raw materials. Firms no longer view their markets as being constrained by national borders; instead, they look to foreign nations as potential markets. As new technology spreads throughout the world, production location decisions are determined more by production costs, and production activity and its

associated flow of components have been dispersed around the world. At the same time, increased integration of international financial markets has been prompted by technology, ingenuity, and deregulation. Technological advances in communications and computers have revolutionized the speed with which financial information about asset returns and risk is collected, processed, and disseminated throughout the world. Advances in the understanding of finance have helped accelerate the innovation of new instruments to manage financial risk. In addition, wide-ranging deregulation of domestic and cross-border financial flows has allowed greater scope for competitive forces in financial markets and spurred the growth of various forms of financial intermediation. Increased international integration of both goods and financial markets has had an impact on the environment for monetary policy as well. It has expanded the range of shocks that must be accounted for when implementing domestic monetary policy. It also has affected the channels through which monetary policy is transmitted. It has not changed the appropriate goal of domestic monetary policy, however. That goal remains domestic price stability; as extensive research and harsh experience have shown, controlling inflation is the main thing monetary policy can, and should, do. EXPOSURE TO FOREIGN SHOCKS The closer integration of cross-border capital and goods markets implies that foreign shocks become additional sources of disturbance to the domestic economy and therefore a concern to domestic policymakers. For example, foreign real demand shocks, such as an unexpected decline in the overall level of economic activity abroad, can dampen the demand for domestic exports and act as a drag on the domestic economy. Foreign real supply shocks, e.g., a decline in the availability of world oil resources, can reduce domestic productive capacity and raise the overall domestic price level. Foreign nominal shocks, such as cyclically contractionary monetary policy and temporarily higher interest rates abroad, can lead to capital outflows and temporarily higher domestic interest rates. As domestic markets become more integrated with those abroad and the relative magnitude of foreign transactions increases, these shocks play a greater role in the short-run transmission to domestic output and inflation. For example, foreign real demand and supply shocks now have a bigger effect on the U.S. economy than they did when exports and imports were smaller relative to GDP. And greater international financial linkages mean that the U.S. financial sector is more exposed to foreign nominal shocks than it once was. Does the increased vulnerability to foreign shocks, real or nominal, imply that domestic interest rates and, hence, domestic prices are exposed to undue influence from abroad? Does this linkage then limit the ability of the Federal Reserve and other central banks to conduct monetary policy in pursuit of price stability? The answer depends on a number of factors, including the degree of integration, the relative size of the country, and the choice of flexible versus fixed exchange rate regimes. Ceteris paribus, each factor influences the effect of foreign shocks on both the domestic interest rate and the domestic price level. Degree of Integration. In spite of the increased integration in the past thirty years, the global financial marketplace is not as integrated as one might think. Although many of the legal barriers to international capital mobility are now gone, payments still must be settled in specific currencies, and the world capital market is to a large extent

still segmented along national lines. Evidence of this segmentation is the strong correlation between national rates of saving and investment. Although there are large daily flows of capital around the world, when the dust settles, most of the saving done in each country remains invested in that country. The large gross international flows of funds are often part of offsetting asset and liability transactions that leave no net transfer of capital from one country to another. 1 Additional evidence is provided by the so-called "home bias" in the composition of investment portfolios. Foreign investments, on average, represent less than 10 percent of U.S. portfolios, for example. The percentage of foreign investments in Japanese portfolios is only slightly higher, and only 15 percent of German portfolios is in foreign assets.2 Thus, although the home bias in investments is considerably less than it was ten years ago, the financial markets are still far from fully globalized. In large part, this is because investors ultimately consume in their home currencies and wish to avoid foreign exchange risk. Moreover, they may be fearful of investing in countries they do not understand as well as they do their own, or they may be uninformed about opportunities abroad. This home bias gives a good deal of latitude for domestic monetary policy control. The globalized goods market also is by no means fully integrated. For example, services and other goods, such as health care, construction, and so on, tend not to be traded internationally because of transportation costs and other characteristics.3 In the United States and most other industrial nations, more than 60 percent of consumption is in services and other goods such as these. Because the prices of these nontraded goods and services are not directly affected by foreign price developments, and because these goods and services represent the large majority of domestic consumption, domestic price developments weigh far more heavily in the overall domestic price level than do foreign price developments. Relative Size of the Domestic Economy Another factor that limits the potential impact of foreign developments on domestic interest rates and prices is country size. To the extent that domestic interest rates and prices depend on global factors, a small country, by definition, must treat these factors as exogenous. However, a very large country, such as the United States, still retains some influence to affect world interest rates and prices because of its sheer size. The United States is still the world's largest economy, in terms of both output and financial activity. It accounts for roughly 20 to 25 percent of total world output and-as best as can be measured-roughly 50 percent of global financial wealth. Exchange Rate Policy In addition to the degree of integration and relative size of an economy, the choice of exchange rate regime greatly influences the control a country's central bank has over monetary policy, as well as the extent to which the domestic economy is disturbed by foreign shocks. The key to the relationship between the exchange rate policy and the conduct of domestic monetary policy is portrayed in the principle that is sometimes called the "unholy trinity" of international economics: A country cannot simultaneously have (1) freely mobile crossborder capital flows, (2) a fixed or managed exchange rate, and (3 ) an independent domestic monetary policy, i.e., control of domestic interest rates. Thus, countries with open capital markets face a choice between fixed exchange rates, which determine domestic monetary policy, and flexible exchange rates, which permit the central bank to set domestic interest rates through independent monetary policy.

FLEXIBLE EXCHANGE RATES As the "unholy trinity" suggests, under flexible exchange rates, a central bank can pursue an independent monetary policy, i.e., it retains control of the money supply and the ability to influence domestic interest rates. For example, domestic monetary restraint that raises domestic interest rates relative to foreign rates also raises the demand for domestic-denominated assets, generates capital inflows, and brings about an appreciation of the domestic currency. This, in turn, stimulates spending on imports and restrains spending on exports. The resulting decline in net exports enhances the effectiveness of the monetary contraction by further curbing aggregate demand for domestic output. Thus, not only do flexible exchange rates preserve monetary policy independence, they also magnify the effects of monetary policy on domestic aggregate demand: all else equal, a monetary policy tightening of a given magnitude has a greater effect on demand with flexible exchange rates than with fixed exchange rates.4 It should be emphasized, however, that even if continuing financial innovation and integration do make aggregate demand more or less sensitive to policy, a central bank can always adjust its response to compensate for the change. For example, if demand is more sensitive to given interest rate changes, the central bank can apply less pressure on the level of interest rates to achieve a given effect on aggregate demand. Thus, the Federal Reserve and other central banks operating under flexible exchange rate regimes still have the tools required to implement monetary policy, even if the more global environment adds some uncertainty about the multiplier effects of these tools. Flexible exchange rates also help buffer domestic interest rates from foreign shocks. In the case of a foreign nominal shock, such as a contractionary monetary policy abroad that temporarily raises foreign interest rates, a flexible exchange rate regime allows the domestic currency to depreciate in response to capital outflows, lessening the pressure for domestic interest rates to rise. In the case of a temporary decline in foreign fiscal spending, flexible exchange rates also may work to insulate domestic interest rates. A temporary foreign fiscal contraction lowers the foreign interest rate and induces capital inflows to the domestic economy. The resulting appreciation of the domestic currency dampens the pressure for a fall in domestic interest rates.5 Flexible exchange rates also help insulate the domestic price level from some foreign shocks. In the case of tighter foreign monetary policy, for example, lower foreign prices raise domestic demand for imports and on foreign demand for exports.6 The resulting rise in demand for foreign exchange leads to a depreciation of the domestic currency. This dampens the domestic demand for imports, raises foreign demand for exports, and lessens the pressure for domestic prices to fall. It is important to note that this does not mean that specific industries or sectors feel no competitive pressures from low-cost foreign producers. Rather, it means that, ceteris paribus, the more a country with flexible exchange rates tries to import, the more downward pressure there is on the foreign exchange value of its currency. As a result, the domestic cost of foreign goods goes up, lessening the impact of low foreign costs on the domestic price level. Of course, at any point in time, the value of a currency also reflects other factors that may obscure the effect of this mechanism. For example, in the current environment, the U.S. trade deficit is large and increasing, yet the dollar is not falling, but instead is strong, relative to other currencies. This most likely reflects the perception of exceptional risks in many Asian economies or, alternatively, of the U.S. dollar as a "safe haven," given the economic and political difficulties abroad. To achieve a given inflation goal, the

dollar appreciation implies that the Fed can enjoy an environment of lower interest rates than if the dollar were weaker. In addition, the adjustment mechanism may be complicated, and it may take time for the effects of exchange rates to pass through to import prices and volumes. But to the extent these lags are predictable, the Federal Reserve can expect the pattern of lower interest rates to counterbalance the path of the higher dollar.7 FIXED EXCHANGE RATES Fixed rate regimes have been chosen by a number of countries, notably the smaller open economies, because they often have needs and goals that are somewhat different from those countries that choose flexible exchange rates. Some countries have sought fixed exchange rates with other trading partners in order to reduce transactions costs associated with cross-border activities. This is one of the rationales given for participation in the European Monetary System (EMS) and its designated successor, the European Monetary Union (EMU).8 Other economies have sought to limit the adverse effects of exchange rate movements on international relative prices and trade flows. This was the rationale for the relatively fixed exchange rates of many countries in the Pacific Basin, as they tried to keep the value of their currencies relatively stable vis a vis the dollar. Moreover, high inflation countries, such as several in Latin America in the 1970s and 1980s, often have been attracted to fixed exchange rates as a nominal anchor for private sector price expectations as part of an anti-inflation stabilization program. When capital mobility is high and a country pegs its exchange rate to another country's currency, its domestic interest rates will be linked to foreign interest rates, which severely limits its ability to pursue an independent domestic monetary policy. For example, a tightening of domestic monetary policy that raises domestic rates above foreign rates also induces capital inflows in response to the cross-border return differential; this dampens the initial rise in domestic interest rates; it also induces lower domestic demand for imported goods, which further dampens the contractionary effects of the higher interest rate. Thus, under a pegged exchange rate, control of domestic interest rates and the aggregate demand impact of monetary policy are limited. At times, some central banks with fixed exchange rates have tried to peg the level of the exchange rate while still trying to maintain independent domestic monetary policy goals by using sterilized exchange market intervention. Sterilized intervention typically involves government support of its exchange rate by selling foreign exchange reserves, and then sterilizing (undoing) the potential contractionary effect on the domestic monetary base through a simultaneous and equal purchase of domestic currency bonds. The net effect is to leave the domestic money supply and hence monetary policy unaffected. However, because sterilized intervention does not change any fundamental determinants of the exchange rate, such as relative money supplies, it cannot by itself have a long-run impact on the exchange rate. Thus, sterilized intervention usually has no more than a marginal and temporary effect on the exchange rate.9 TRYING TO AVOID THE UNHOLY TRINITY Recent history provides a number of dramatic examples of the constraints imposed by the "unholy trinity." The EMS, like the Bretton Woods System, started with pegged but adjustable exchange rates. Frequent alterations in actual rates, and in the pegs, occurred between 1970 and 1987. The EMS held together until it was transformed in the latter part of the 1980s into a fixed rate system, in which member countries essentially pegged their currencies within a narrow band around the deutsche mark, while to varying

degrees they sought to maintain independent monetary policies. At the same time, they increasingly allowed capital to move freely across each other's borders in search of the highest returns. That meant that each member country had only limited ability to set its interest rate differently from Germany's, the largest economy in the region. This constraint was put to the test most dramatically in the early 1990s. As Germany raised its interest rates to fight inflation following reunification, other countries-including the United Kingdom, Italy, Spain, Portugal, and eventually France-found the higher German interest rates onerous. In 1992 the system was overwhelmed by large speculative flows of capital, and consequently some countries dropped out of the EMS and let their currencies depreciate in order to allow their domestic interest rates to diverge from those in Germany. In 1993 the speculative pressures continued, and ultimately the EMS widened the exchange rate bands within which individual currencies were pegged to the deutsche mark, and more currencies depreciated. In contrast, some member countries, such as Austria and the Netherlands, were able to maintain close pegs to the deutsche mark because they were willing to mirror the Bundesbank's monetary policies. The Mexican peso crisis of 1994-95 and the Asian currency crisis of 1997-98 provide more recent examples of how fixed exchange rate arrangements necessarily constrain domestic monetary policies. They also demonstrate how financial markets can rapidly punish policy misalignments, actual or perceived, and force abandonment of exchange rate pegs. In the case of Mexico, policymakers faced capital flight following upward U.S. interest rate movements and Mexican political developments in 1994. Efforts by Mexico's central bank to avoid raising domestic interest rates while also limiting depreciation of the peso proved unsustainable and contributed to the crisis. The origins of the Asia crisis were in part related to the fact that several countries linked their currencies to the dollar at a time when the dollar appreciated relative to the Japanese yen and Chinese renminbi. With the baht and the rupiah and other linked currencies rising relative to the yen and the renminbi, the products of Thailand, Indonesia, etc., grew more expensive relative to Japan's and China's products. The decline in their competitiveness put pressure on their currencies to depreciate.10 These examples illustrate how emerging markets as well as industrial countries often have not been able to make credible commitments to fixed exchange rates for more than a few years. " Although it is technically feasible for a country to maintain a pegged exchange rate as long as its central bank has access to enough foreign exchange reserves to respond to speculative attacks, its central bank also must be willing always to subordinate all the other goals of monetary policy. In practice, this means that it must have the resources to buy enough of the monetary base and be willing to raise domestic interest rates high enough to maintain the attractiveness of its currency to speculators. Hong Kong and Argentina are among the few economies that have succeeded in maintaining exchange rate pegs for several years. They have done so by establishing currency board arrangements that limit discretionary actions of their central bank. Technically, this requires that all changes in dollar reserves holdings associated with balance of payments imbalances more or less automatically affect the monetary base of the economy and not be sterilized But, as the examples above show, many countries with pegged exchange rate regimes at some time or another have found forgoing an independent monetary policy to be a price too high to pay, particularly when

high domestic rates adversely affect domestic unemployment or financial sector stability. In other words, countries with pegged or fixed exchange rate regimes are often not prepared to abandon completely the use of monetary policy for stabilization purposes. With their priorities in doubt, they are more likely to become lightning rods for speculative attack.12 Even Hong Kong and Argentina face continual pressure from speculators testing the credibility of their pegs. Thus, many emerging as well as industrial economies recently have come to allow greater flexibility of their exchange rates.13 CONCLUDING COMMENTS The increased international integration of financial markets and goods markets has not fundamentally altered the effectiveness of monetary policy or its goal of low inflation. In flexible exchange rate regimes, domestic monetary policy still can be implemented in terms of monetary aggregates or interest rates to pursue price stability. In pegged exchange rate regimes, cross-border capital movements limit a country's ability to set independent monetary policy; thus, price stability requires maintaining a peg with the currency of some foreign economy with stable prices. However, to the extent that pegged exchange rate regimes are becoming less viable, particularly as speculative capital flows test the credibility of central bank commitments, alternative approaches to the pursuit of price stability become necessary. This may involve allowing greater exchange rate flexibility or, as in the case of the EMU, moving to a single currency. Increasing globalization has created new issues and challenges in how the Federal Reserve and other central banks formulate monetary policy, and it has expanded the range of shocks that must be accounted for when implementing domestic monetary policy. It also has affected the channels through which monetary policy is transmitted to the domestic economy. Thus, for example, U.S. policymakers must assess how the current Asian downturn might affect the U.S. outlook for inflation and output and then make appropriate adjustments to domestic monetary policy, keeping in mind its long-term price inflation stability goal. As an illustration, the significant appreciation of the dollar during the past several years clearly has had a temporary restraining effect on U.S. inflation and has affected the conduct of monetary policy. The exchange of information and the coordination of regulatory policies also has taken on more importance in today's global environment. National central banks take part in many international forums to exchange information on conditions in various economies and on global macroeconomic issues. In addition, there are also ongoing discussions about international crisis management and a growing interest in global standards for risk management in financial institutions, including cooperation in sharing information about the performance and risk activities of private sector financial institutions operating across national boundaries. The need for coordinated policymaking is particularly strong in the arena of financial supervision and regulation, because financial integration problems in one country's financial sector can be quickly transmitted to other countries' financial systems through debt defaults or contagion. The recent problems of financial institutions in Asia have driven this lesson home again. Footnote FOOTNOTES 1 For example, a portfolio manager who hedges the currency risk of an overseas investment can bet on foreign stocks or bonds without any net cross-border capital transfer. Footnote

2 These figures may understate the degree of financial integration, to the extent that domestic firms in which people invest also operate or hold assets abroad. 3 This remains true in spite of the fact that certain types of services have become more "tradable" as lawyers, consultants, etc., have become more mobile internationally. 4 Flexible exchange rates do not insulate domestic interest rates if the foreign real shocks are permanent. For example, a permanent decline in foreign real investment demand or fiscal spending that lowers the foreign real interest rate also will lower the real domestic interest rate, because, in the long run, foreign and domestic asset returns are equalized in an integrated world economy (so long as the assets are perfectly substitutable, and hence there is no risk premium). Because the associated decline in foreign aggregate demand generally reduces demand for foreign goods by more than it reduces demand for domestic goods, there will also be a long-run depreciation in the real value of the foreign currency to maintain demand for foreign output. Thus a flexible exchange rate will not insulate the domestic interest rate from permanent real shocks. In this instance, adjustment of domestic fiscal policy may be used to offset the decline in domestic interest rates. 5 The deflationary pressure on domestic prices associated with tighter foreign monetary policy will be reinforced by the decline in foreign demand for domestic exports stemming from slower growth abroad. Footnote 6 Flexible exchange rates do not insulate domestic aggregate demand and prices from all foreign shocks. In the case of a decline in foreign fiscal spending, for example, the appreciation of the domestic currency in response to lower foreign interest rates decreases foreign demand for domestic exports. In addition, the decline in foreign fiscal spending lowers foreign aggregate demand and further reduces demand for domestic good exports. Through both channels the deflationary effects of contractionary foreign fiscal policy are transmitted to the domestic economy. 7 The EMU takes this logic one step further by its intended elimination of the national currencies of all member states. Footnote 8 In theory, if domestic and foreign currency bonds are imperfect substitutes, sterilized intervention can have some impact on the exchange rate by affecting the relative holdings of bonds and hence the risk premium. But such an effect appears to be small empirically (Edison, 1993). 9 Sterilized intervention may still be useful, however, when the exchange rate has diverged to a significant degree from fundamentals, and the intervention induces a refocus of the market on fundamentals or signals a future change in policy fundamentals. 10 Other important factors also were at work in the Footnote Mexican and Asian crises, including fragile banking systems and possibly elements of bank depositor panic. ti See Obstfeld and Rogoff (1995). 12 Of course, there is always the option of resorting to capital controls. But this would be a step backwards

from the trend toward financial market liberalization and, in the end, would not be effective in today's competitive markets. 13 To the extent that the EMU countries succeed in forming a monetary union, they will be an exception to this trend. However, this success will be based on the eventual adoption of a single currency in Europe, which itself embodies the political will of member states to give up independent monetary control, and thus independent monetary objectives. References REFERENCES Edison, Hali. 1993. "The Effectiveness of Central Bank Intervention: A Survey of the Literature after 1982" in Special Papers in International Economics, No. 18. Princeton: Princeton University, Department of Economics, International Finance Section. Obstfeld, Maurice, and Kenneth Rogoff. 1995. "The Mirage of Fixed Exchange Rates," Journal of Economic Perspectives (Fall), 73-96. AuthorAffiliation * Robert T. Parry is President and Chief Executive Officer, Federal Reserve Bank of San Francisco, San Francisco, CA. He also is a Fellow and former President of NABE and an Associate Editor of this journal.