Monetary Policy Essays (5418 words) - Foreign Exchange Market

Monetary Policy International Dimensions to U.S. Monetary Policy Executive Summary Federal Reserve monetary policy has traditionally focused on the domestic economy. Over time, however, a number of significant trends have underscored the potential importance of the international dimensions of contemporary monetary policy. Such trends include the following: ? Financial markets continue to become increasingly integrated internationally; capital is evermore mobile. ? The U.S. dollar continues to remain the world's principal international currency despite evolving exchange rate arrangements. ? Official and unofficial dollarization has continued in several emerging market economies. These trends suggest that monetary policy may have differing transmission mechanisms increasingly involving international variables than was earlier the case. In addition to these trends, empirical evidence recently has accumulated showing that changes in U.S. monetary policy can significantly impact emerging market economies in a number of ways. For example, changes in U.S. monetary policy can (1) dominate capital flows in emerging market economies, (2) be associated with financial crises in these countries, and (3) significantly impact interest rates and financial markets in emerging economies under differing exchange rate arrangements. Furthermore, experience shows that the Federal Reserve can successfully assume international lender-of-last-resort responsibilities and stabilize world financial markets in situations of international liquidity crises. The Federal Reserve should increasingly recognize these international considerations when conducting monetary policy. International Dimensions to U.S. Monetary Policy I. Introduction Traditionally, Federal Reserve monetary policy has focused on the domestic economy. Although international factors have not been ignored, they have been subordinate to domestic concerns. International concerns are rarely important rationale influencing Federal Reserve monetary policy decisions; further, the global impacts of U.S. monetary policy decisions seldom receive much attention from monetary officials. Recent trends and developments, however, suggest this domestic orientation may not be entirely satisfactory for U.S. monetary policy. There is a growing recognition of the fact that financial capital is increasingly mobile, and financial markets are evermore globally integrated. At the same time, varying degrees of dollarization have occurred in several emerging market economies and the dollar remains the world's principal international currency despite evolving developments in exchange rate arrangements. These considerations have a number of important implications for U.S. monetary policy. For example, they help to explain why changes in U.S. monetary policy can have increasingly potent effects on emerging market economies that should be recognized and why the Federal Reserve's implicit international lender-of-last-resort (LOLR) responsibilities are so important.1 These international considerations can be taken into account by anchoring prices with a price stabilization policy goal and using key market price indicators as policy guides. After briefly describing these evolving circumstances -- namely, increased capital mobility, dollarization, and the international role of the dollar -- this paper briefly reviews the evidence suggesting that changes in Federal Reserve monetary policy have implications for both emerging markets and the global economy. Implications for the Federal Reserve's international LOLR role are highlighted and some recommendations for monetary policy are outlined. Recent Trends and Developments ? Increasing Financial Integration and Growing Capital Mobility. Clearly, one important trend of recent years is increasing international financial integration and growing capital mobility.2 Most economists now recognize the inexorable trend toward globalization or growing international integration of financial markets and increasing capital mobility. Empirical results, for example, increasingly provide evidence of growing capital mobility. In particular, data on capital flows as well as interest rate differentials indicate that a growing degree of capital market integration or increased capital mobility has occurred since the 1970s.3 The U.S. economy, along with most other economies, is more open. Many experts believe these trends are largely inevitable and irreversible, partly because they are being driven by communications and informational technological change and partly because policymakers increasingly recognize the many compelling benefits of regulatory changes that foster financial integration.4 Accordingly, a growing consensus among econo mists is that there is no turning back: i.e., that capital mobility is here to stay.5 There are a number of important implications of this increased international financial integration. This more open environment, for example, implies that changes in monetary policy involve a somewhat different transmission mechanism. In particular, the more integrated the economy, the more quickly and substantially do divergent policies affect financial markets and capital flows. And the foreign exchange rate may play an increasingly