Conducting monetary policy in a global economy

Business Economics, Oct, 1998 by Robert T. Parry

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.l