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International Channels of Transmission of Monetary Policy and the Mundellian Trilemma

Abstract

This lecture argues that the Global Financial Cycle is a challenge for the validity of the Mundellian trilemma. The paper presents evidence that U.S. monetary policy shocks are transmitted internationally and affect financial conditions even in inflation-targeting economies with large financial markets. Hence flexible exchange rates are not enough to guarantee monetary autonomy in a world of large capital flows.

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Notes

  1. 1.

    Long rate correlations however seem independent of the exchange-rate regime (see Obstfeld, 2015).

  2. 2.

    This is of course not a statement that exchange rates or exchange rate regimes do not matter at all nor that the Mundell-Fleming Model should be discarded.

  3. 3.

    See Woodford (2003) and Gali (2008) for a precise description of the model. For a recent survey on monetary transmission mechanisms, see Boivin, Kiley, and Mishkin (2010).

  4. 4.

    The older literature on international monetary cooperation (see Bryant and others, 1988) has also typically found low gains from coordination. Farhi and Werning (2014) show that it may be optimal for central banks to smooth their terms of trade in a way that cannot be achieved solely with the policy rate (not enough instruments for all the targets). Bergin and Corsetti (2015) consider a model with a production externality, which may make gains from international cooperation higher.

  5. 5.

    The financial accelerator mechanism (Bernanke, Gertler, and Gilchrist, 1996) has been mostly studied in the context of closed economies and initially applied to nonfinancial corporations and households (Kiyotaki and Moore, 1997). There is a rapidly growing literature modeling some type of financial friction: Lorenzoni (2008), Fostel and Geanakoplos (2008), Christiano, Motto, and Rostagno (2014). Recently, there has been a flurry of models featuring explicitly financial intermediaries (for example, Gertler and Karadi, 2011; Curdia and Woodford, 2010; Gertler and Kiyotaki, 2010; Brunnermeier and Sannikov, 2014; He and Krishnamurthy, 2013; Adrian and Boyarchenko, 2012; Coimbra, 2015).

  6. 6.

    See Adrian and Shin (2014) for a microfoundation of this constraint.

  7. 7.

    Another potentially related channel of transmission of monetary policy is the “search for yield” (Rajan, 2005). In a low interest rate environment, investors take on additional risk in order to secure higher yields. This could explain portfolio shifts from short-run to long-run assets and to emerging market assets when policy rates remain low for extended time periods.

  8. 8.

    It is worth remembering that credit booms have been found to be the best predictor of financial crises (Gourinchas and Obstfeld, 2012; Schularick and Taylor, 2012).

  9. 9.

    Bruno and Shin (2015b) is an exception for the “risk-taking channel.”

  10. 10.

    Farhi and Werning (2015) study a range of models with aggregate demand externalities or pecuniary externalities. In particular they analyze a model with nominal rigidities, market incompleteness, and foreign currency debt. They too find that additional tools (in their case taxing foreign currency debt) is optimal.

  11. 11.

    See, for example, Krugman (1980), Portes and Rey (1998), Rey (2001), Chinn and Frankel (2007), Papaoiannou and Portes (2008), Eichengreen (2011), Prasad (2014).

  12. 12.

    See Despres, Kindleberger, and Salant (1966), Kindleberger (1965), Gourinchas and Rey (2007a and 2007b), Gourinchas, Rey, and Govillot (2010), Maggiori (2013) and Gourinchas and Rey (2014).

  13. 13.

    Exceptions are Calvo, Leiderman and Reinhart (1996), Cetorelli and Goldberg (2012), Shin (2012), Passari and Rey (2015).

  14. 14.

    Because of the size of the U.S. market in the world economy, a monetary loosening by the Federal Reserve may have a nonnegligible effect on U.S. imports, which in turn will affect the income and net worth of exporting firms in other countries.

  15. 15.

    The global financial cycle is different from the national financial cycles described by Drehmann and others (2012) who emphasize the domestic cycles in credit and real estate prices.

  16. 16.

    Longstaff and others (2011) find a very large role for a global component in sovereign CDS. They show that sovereign credit spreads are more related to the U.S. stock and high-yield markets than they are to local economic measures.

  17. 17.

    Other large monetary and financial areas are also likely to have an influence. The euro area, Japan, China, the United Kingdom and possibly Switzerland come to mind. I only study the United States in this lecture which is justified given the key role of the United States in the international financial and monetary system.

  18. 18.

    Bekaert, Hoerova, and Lo Duca (2013) analyze the effect of U.S. monetary policy on the VIX, decomposing it into a risk aversion component and a volatility component.

  19. 19.

    The discussion follows closely Stock and Watson (2008).

  20. 20.

    One could also in principle instrument for the two-year rate. Gertler and Karadi (2015) do extensive robustness checks and show that the strength of the instrument is higher for the one-year rate.

  21. 21.

    For more details, see Mertens and Ravn (2013).

  22. 22.

    In Passari and Rey (2015), we show that comovements in gross capital flows are important regardless of the exchange rate regime. Additionally we show that in the cross-section, sensitivities of the local stock market and of credit growth to the VIX are not significantly affected by exchange rate regimes.

  23. 23.

    For a subset of these economies, there is no sign that the domestic policy rate reacts to U.S. monetary policy shocks. The systematic part of the United States and other countries monetary policies may of course be correlated because of fundamental linkages and common shocks.

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Authors

Additional information

*Hélène Rey is Professor of Economics at London Business School. Her research focuses on external imbalances, financial crises, the links between monetary policy and the financial sector, and the organization of the international monetary system. In 2006, she received Bernácer Prize, in 2012, the inaugural Birgit Grodal Award, in 2013 the Yrjö Jahnsson Award jointly with Thomas Piketty, and in 2014 the inaugural Carl Menger Preis. This is the Mundell-Fleming lecture given at the IMF on November 13, 2014. The author is very grateful for the comments of Olivier Blanchard, Pierre-Olivier Gourinchas, Richard Portes, Jay Shambaugh. She benefitted greatly from exchanges with Ben Bernanke, Claudio Borio, Refet Gurkaynak, Nobuhiro Kiyotaki, Silvia Miranda-Agrippino, Maury Obstfeld, Hyun Shin, and Michael Woodford. The author is also very grateful to Peter Karadi and Mark Gertler for sharing their data on monetary surprises, to James Wong for help with the New Zealand data, to Bo Young Chang for the Canadian data, and to Stefan Avdjiev for the BIS data. Elena Gerko and Evgenia Passari provided outstanding research assistance.

An erratum to this article is available at http://dx.doi.org/10.1057/s41308-017-0034-4.

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Appendices

Appendix I

Data Appendix

U.K.

Data are monthly: 1995:01–2012:06 (short series due to the nonavailability of a long mortgage series). IP (seasonally adjusted), CPI (seasonally adjusted), and FX are from FRED St Louis (Board of Governors of the Federal Reserve System (U.S.)). Rates are from Bank of England website. Policy rate is the “Official Bank Rate.” Mortgage spread: monthly interest rate of U.K. monetary financial institutions (excl. Central Bank) sterling five-year (75 percent LTV) fixed rate mortgage to household—Yield from British Government Securities (five-year).

Canada

Data are monthly: 1985:03 to 2012:06. IP (seasonally adjusted), CPI (seasonally adjusted), and FX are from FRED St Louis (Board of Governors of the Federal Reserve System (U.S.)). Rates are from Bank of Canada website (www.bankofcanada.ca/rates/interest-rates/selected-historical-interest-rates/). Policy rate is “Bank Rate” (V122530). Mortgage rate is “Chartered bank administered interest rates- conventional mortgage 5 year” (V122521). To construct the mortgage spread I used five-year yield (“selected government of Canada benchmark bond yields-5 year,” V122540).

Sweden

Data are monthly from 1987:01 to 2012:06. IP (seasonally adjusted), CPI (seasonally adjusted), and FX are from FRED St Louis (Board of Governors of the Federal Reserve System (U.S.)). Interest rates data are from: www.riksbank.se/en/Interest-and-exchange-rates/search-interest-rates-exchange-rates/. Policy rate is constructed as Marginal rate (01/1987–05/1994) and Repo rate (06/1994–06/2012). Mortgage spread is constructed as Mortgage Bond (five-year)—Swedish Government Bonds (five-year).

New Zealand

Quarterly data: 1987:Q3 to 2012:Q3 (due to the nonavailability of monthly series from CPI and GDP or IP). CPI and GDP are seasonally adjusted and from IFS, IMF. The policy rates come from the Central Banks’ website: Overnight interbank cash rate hb2-monthly. Mortgage Spread: difference between the housing lending (floating first mortgage new customer housing rate), column G, spreadsheet hb3 and the 10-year secondary market government bond yield, column S, spreadsheet hb2.

Appendix II

U.S. Monetary Policy Spillovers

Figure A1

Figure A1
figure9

Effect of U.S. Monetary Policy Shocks on Canada

Notes: Monthly data over the period 1985:03 to 2012:06. The instruments (Fed funds futures FF4) are available from the period 1991:01 through 2012:06. The VIX is replaced by the exchange rate. The F-stat is 10.01. I report 90 percent confidence intervals.

Figure A2

Figure A2
figure10

Effect of U.S. Monetary Policy Shocks on Sweden

Notes: Monthly data over the period 1987:01 to 2012:06. The instruments (Fed funds futures FF1) are available from the period 1991:01 through 2012:06. The VIX is replaced by the exchange rate. The F-stat is 16.88. I report 90 percent confidence intervals.

Figure A3

Figure A3
figure11

Effect of U.S. Monetary Policy Shocks on the United Kingdom

Notes: Monthly data over the period 1995:01–2012:06 (due to lack of mortgage series on a longer sample). The instruments (Fed funds futures FF1) are available from the period 1991:01 through 2012:06. The F-stat is 12.5. I report 90 percent confidence intervals. The VIX is replaced by the exchange rate.

Figure A4

Figure A4
figure12

Effect of U.S. Monetary Policy Shocks on New Zealand

Notes: Quarterly data over the period 1987:Q2 to 2012:Q2 . The instruments (Romer and Romer) are available through 2009:Q1. The F-stat is 10.07. I report 90 percent confidence intervals. The VIX is replaced by the exchange rate.

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Rey, H. International Channels of Transmission of Monetary Policy and the Mundellian Trilemma. IMF Econ Rev 64, 6–35 (2016). https://doi.org/10.1057/imfer.2016.4

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