Global economic integration and monetary policy - A Review of Federal Reserve Policy

Business Economics, July, 1991 by Manuel H. Johnson, Robert E. Keleher

A number of key forces have forged significant changes in the environment facing monetary policymakers. This changed environment must be taken into account in selecting appropriate policy tools as well as in actually formulating and implementing monetary policy. After reviewing these changes as well as the forces bringing them about, this article summarizes three important implications for contemporary monetary policy. In particular, the appropriate data to use in conducting monetary policy, the importance of a nominal anchor under a flexible exchange regime, and the significance of coordinating monetary policy among several countries are discussed.

ANY CONTEMPORARY DISCUSSION of monetary policy must recognize the increasingly important integration of the global economy. And competent monetary policymakers must understand the policy implications of this increased integration as well as how to achieve monetary stability in a well-integrated world economy.

This paper discusses the formulation and implementation of monetary policy by central banks in a deregulated, globally integrated financial system. In short, it discusses monetary policymaking in circumstances that approximate those existing today.

Before discussing the details of such policy-making, however, it is useful to describe briefly the nature of the current monetary regime in which we operate as well as the forces shaping change in modern economic and financial systems.

THE CURRENT REGIME

The world's major trading areas generally operate under a fiat money/flexible exchange rate regime. Admittedly, currency arrangements appear to be evolving into a system of multipolar currency blocs. Smaller countries tend to peg their currencies to those of their larger trading partners, fostering the formation of large currency areas. The currencies of the larger countries, however, float against one another. Thus, the term flexible" is used advisedly; perhaps "managed" or "semi-" float would be more appropriate.

A good deal of (largely sterilized) intervention has occurred in recent years. Nevertheless, exchange rates between major trading regions move frequently and often by substantial magnitudes. These movements have led many observers to argue that foreign exchange rates are both excessively volatile and frequently "overshoot" their equilibrium values.

Exchange rate movements, however, play an increasing role in the transmission of changes in monetary policy and can play a significant role in fostering balance-of-payments adjustment. In spite of these movements in exchange rates, reserve holdings among key countries have increased; this conflicts with the common belief that reserve holdings would decline with the abandonment of the Bretton Woods system. Furthermore, the dollar continues to serve as a key reserve currency under current international monetary arrangements.

FORCES OF CHANGE

A number of forces have worked to shape our current environment. Revolutions in telecommunications and information processing have dramatically lowered the costs of acquiring, disseminating, and processing information and undoubtedly have quickened the pace of the integration process. These changes fostered a host of financial innovations that enabled price, geographic, and product regulations of various financial services to be readily circumvented. These circumventions and innovations, in turn, promoted some long-sought deregulation of financial services as well as a substantial reduction of international capital controls. All of these changes promoted the efficiency of both financial markets and the global macroeconomy.

These many developments have dramatically changed the world; no part of our world - not even the remaining centrally planned economies - has escaped the effects of these changes. Indeed, the above-cited improvements in the workings of market-based systems underscored the growing problems of centrally planned economies. In particular, the rapid growth of both information and knowledge has contributed to an increasingly complex world; yet this information and knowledge is, by its very nature, decentralized and dispersed. Because of this - and as demonstrated by the socialist-calculation debate of the 1930s - market-based systems employing market-price signals are necessarily more efficient at processing and transmitting information about relative supply and demand conditions and providing incentives to produce and distribute desired goods and services. Thus, it has become increasingly obvious that market-based economies are significantly more efficient at both using dispersed information and knowledge and allocating resources than those command economies under centralized control. Because market economies operate more efficiently, they promote faster growth and higher living standards than centrally planned economies.

SPECIFIC CHARACTERISTICS OF THIS ENVIRONMENT

How do these many changes manifest themselves to the practical policymaker? What types of properties characterize our changed financial environment?