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This speech highlights two channels through which globalization poses challenges for monetary policy. The first channel is through the global determination of the average world natural real rate of interest, which implies that saving and investment shifts abroad can influence the domestic interest rate setting consistent with price stability. The second channel is through global digital payments systems, which may compromise domestic policy sovereignty through effects on both monetary and financial stability.

This paper is a partial exploration of mechanisms through which global factors influence the tradeoffs that U.S. monetary policy faces. It considers three main channels. The first is the determination of domestic inflation in a context where international prices and global competition play a role, alongside domestic slack and inflation expectations. The second channel is the determination of asset returns (including the natural real safe rate of interest, r*) and financial conditions, given integration with global financial markets. The third channel, which is particular to the United States, is the potential spillback onto the U.S. economy from the disproportionate impact of U.S. monetary policy on the outside world. In themselves, global factors need not undermine a central bank's ability to control the price level over the long term -- after all, it is the monopoly issuer of the numeraire in which domestic prices are measured. Over shorter horizons, however, global factors do change the tradeoff between price-level control and other goals such as low unemployment and financial stability, thereby affecting the policy cost of attaining a given price path.

This paper studies how several macrofinancial factors are associated over time with the evolution of covered interest parity (CIP) deviations in the decade after the Global Financial Crisis. Changes in a number of risk- and policy-related factors have a significant association with the evolution of CIP deviations. Key measures of FX market liquidity and intermediaries' risk-taking capacity are strongly correlated with the cross-currency basis (the deviation from CIP), and the close relationship between broad U.S. dollar strength and the basis is driven mainly by a common factor depending on other safe-haven currencies' comovements. Post-crisis monetary policies also play a role, as demonstrated by the relationship between CIP deviations, central bank balance sheets, and term premia. Risk-related factors have more explanatory power than monetary policy-related factors over the entire 2010–2018 period, but they are approximately equally influential over the period's second half. Further highlighting the role of bank regulation, we offer evidence that the year-end dynamics of the three-month dollar basis depend on financial regulations targeting global systemically important financial institutions.

This speech highlights two channels through which globalization poses challenges for monetary policy. The first channel is through the global determination of the average world natural real rate of interest, which implies that saving and investment shifts abroad can influence the domestic interest rate setting consistent with price stability. The second channel is through global digital payments systems, which may compromise domestic policy sovereignty through effects on both monetary and financial stability.

This paper is a partial exploration of mechanisms through which global factors influence the tradeoffs that US monetary policy faces. It considers three main channels. The first is the determination of domestic inflation in a context where international prices and global competition play a role, alongside domestic slack and inflation expectations. The second channel is the determination of asset returns (including the natural real safe rate of interest, r*) and financial conditions, given integration with global financial markets. The third channel, which is particular to the United States, is the potential spillback onto the US economy from the disproportionate impact of US monetary policy on the outside world. In themselves, global factors need not undermine a central bank's ability to control the price level over the long term--after all, it is the monopoly issuer of the numeraire in which domestic prices are measured. Over shorter horizons, however, global factors do change the tradeoff between price-level control and other goals such as low unemployment and financial stability, thereby affecting the policy cost of attaining a given price path.

This paper considers the use of new Keynesian open economy models to evaluate monetary policy rules. While recognizing the importance policy evaluation with such models, it presents a number of criticisms about assumptions relating to wage determination, the real interest rate, divine coincidence and financial stability.

This paper revisits the sticky-price pricing-to-market model of Devereux and Engel [Devereux, M.B., Engel, C., 2003. Monetary policy in the open economy revisited: price setting and exchange-rate flexibility. Review of Economic Studies 70(4), 765–783], in which fixed exchange rates are optimal even in the face of country-specific nonmonetary shocks. We show that this result hinges critically on the Devereux–Engel model's prediction that international consumption levels are perfectly synchronized under flexible prices. Realistic modifications of the model that produce nonsynchronous consumption movements – such as, the presence of nontraded goods – upset the fixed exchange rate prescription even in the absence of an expenditure-switching role of exchange rate changes.

Routine publication of the forecast path for the policy interest rate (i.e. “conventional forward guidance”) would improve the transparency of monetary policy. It would also improve policy effectiveness through its influence on expectations, particularly when there is a risk of low inflation, and the policy rate is constrained by the effective lower bound. Model simulations indicate that a potent macroeconomic strategy, for returning the Canadian economy to potential, combines conventional forward guidance with a fiscal stimulus. As a response to the effective lower bound constraint, and the decline in the world equilibrium real interest rate, this strategy is preferable to raising the inflation target.

The exchange-rate regime is often seen as constrained by the monetary policy trilemma, which imposes a stark tradeoff among exchange stability, monetary independence, and capital market openness. Yet the trilemma has not gone without challenge. Some argue that under the modern float there could be limited monetary autonomy; others, that even under the classical gold standard domestic monetary autonomy was considerable. This paper studies the coherence of international interest rates over more than 130 years. The constraints implied by the trilemma are largely borne out by history. © 2005 President and Fellows of Harvard College and the Massachusetts Institute of Technology.

The interwar period was marked by the end of the classical gold standard regime and new levels of macroeconomic disorder in the world economy. The interwar disorder often is linked to policies inconsistent with the constraint of the open-economy trilemma—the inability of policymakers simultaneously to pursue a fixed exchange rate, open capital markets, and autonomous monetary policy. The first two objectives were linchpins of the pre-1914 order. As increasingly democratic polities faced pressures to engage in domestic macroeconomic management, however, either currency pegs or freedom of capital movements had to yield. This historical analytic narrative is compelling—with significant ramifications for today’s world, if true—but empirically controversial. We apply theory and empirics to the interwar data and find strong support for the logic of the trilemma. Thus, an inability to pursue consistent policies in a rapidly changing political and economic environment appears central to an understanding of the interwar crises, and the same constraints still apply today.

Prevalent thinking about liquidity traps suggests that the perfect substitutability of money and bonds at a zero short-term nominal interest rate renders open-market operations ineffective for achieving macroeconomic stabilization goals. In an earlier paper, we showed that this reasoning does not hold, that open-market operations can provide substantial macroeconomic benefits and facilitate the use of powerful fiscal policy tools even in a liquidity trap. In this paper, we consider an alternative approach that has been suggested for use in a liquidity trap, a scheduled increase in consumption tax rates. We find that such a policy could, indeed, increase short-run consumption, but would be less effective at increasing welfare or accelerating a country's exit from a liquidity trap. Though a variant of this tax policy might induce exit from a liquidity trap, the impact of welfare is negative in this case as well. We also argue that this alternative tax-rate-based approach is subject to more severe credibility problems than the monetary policy approach explored in our original paper.

Banking systems have rapidly grown to a point where for many countries bank assets amount to multiples of GDP. As a consequence, government fs capacity to provide stability-enhancing fiscal guarantees against systemic crises can no longer be taken for granted. As regulation of dynamic financial markets will inevitably be imperfect, prudent governments need to adjust other facets of macroeconomic policy in order to mitigate financial instability. A precautionary approach to fiscal policy, leading to moderate levels of public debt relative to GDP over the medium term, is essential for the credibility of government promises to support the financial system, as well as the broader economy.

This paper examines the claim that exchange rate regimes are of little salience in the transmission of global financial conditions to domestic financial and macroeconomic conditions by focusing on a sample of about 40 emerging market countries over 1986–2013. Our findings show that exchange rate regimes do matter. Countries with fixed exchange rate regimes are more likely to experience financial vulnerabilities—faster domestic credit and house price growth, and increases in bank leverage—than those with relatively flexible regimes. The transmission of global financial shocks is likewise magnified under fixed exchange rate regimes relative to more flexible (though not necessarily fully flexible) regimes. We attribute this to both reduced monetary policy autonomy and a greater sensitivity of capital flows to changes in global conditions under fixed rate regimes.

This paper explores the links between macroeconomic developments, especially monetary policy, and the exchange rate during the period of Japan's bubble economy and subsequent stagnation. The yen experienced epic gyrations over that period, starting with its rapid ascent after the March 1985 Plaza Accord of major industrial countries. Two distinct periods of endaka fukyo, or recession induced by a strong yen, occurred in the late 1980s and the early 1990s at critical phases of the monetary policy cycle. My approach emphasizes the interaction of short-term developments driven by monetary factors (as they affect international real interest rate differentials) and the long-term determinants of the real exchange rate's equilibrium path. Chief among those long-run determinants are relative sectoral productivity levels and the terms of trade, including the price of oil. Since the mid-1990s, the yen's real exchange rate has generally followed a depreciating trend and Japan's comprehensive terms of trade have deteriorated.

Confronting a prolonged period of slow growth, Japan has recently faced a difficult policy environment, with large budget deficits apparently precluding the use of traditional fiscal stimulus, and zero short-term interest rates apparently precluding the use of traditional monetary stimulus. This paper reconsiders each of these conclusions. In earlier work (Auerbach and Obstfeld 2004a,b), we outlined the case for using monetary policy as an effective tool to stimulate growth, end deflation, and reduce the fiscal burden, even in a zerointerest rate environment. In this paper, we review our basic result and its logic, and consider how our argument is affected by the maturity structure of outstanding government debt and a banking sector that may itself hoard liquidity. We also discuss the issue of credibility, and how our conclusions square with recent Japanese policy experience. We then consider a fiscal policy alternative that has been proposed for Japan, to use variations in tax structure rather than in the level of taxation to stimulate growth in a liquidity trap. We find this policy wanting on both welfare and credibility grounds. I. Introduction Japan’s efforts to stimulate its economy over the past decade have led to apparent macroeconomic policy paralysis, with short-term nominal interest rates at their floor of zero and fiscal expansion immobilized by fears of augmenting an already-huge public debt. In earlier work (Auerbach and Obstfeld 2004a,b), we argued that open- market expansions of the money supply could be used effectively in such an environment, as long as (1) agents in the economy already expect that the liquidit y trap is not permanent; and (2) the monetary policy change is permanent and credible. The economic stimulus from such a policy would come through two channels, from a short-run increase in the inflation rate and a long-run reduction in the tax burden. In this paper, we review our basic result and its logic, and consider how our argument is affected by the maturity structure of outstanding government debt and a banking sector that may itself hoard liquidity. We also discuss the issue of credibility, and how our conclusions square with recent Japanese policy experience. We then consider a fiscal policy alternative that has been proposed for Japan, to use variations in tax structure rather than in the level of taxation to stimulate growth in a liquidity trap. We find this policy wanting on both welfare and credibility grounds.

Author(s): Obstfeld, Maurice; Rogoff, Kenneth | Abstract: It is well known that if international linkages are relatively small, the potential gains to international monetary policy coordination are typically quite limited. But what if goods and financial markets are tightly linked? Is it then problematic if countries unilaterally design their institutions for monetary stabilization? Are the stabilization gains from having separate currencies largely squandered in the absence of effective international monetary coordination? We argue that under plausible assumptions the answer is no. Unless risk aversion is very high, lack of coordination in rule setting is a second-order problem compared to the overall gains from monetary policy stabilization.

The paper develops a simple stochastic new open economy macroeconomic model based on sticky nominal wages. Explicit solution of the wage-setting problem under uncertainty allows one to analyze the effects of the monetary regime on welfare, expected output, and the expected terms of trade. Despite the potential interplay between imperfections due to sticky wages and monopoly, the optimal monetary policy rule has a closed-form solution. To motivate our model, we show that observed correlations between terms of trade and exchange rates are more consistent with our traditional assumptions about nominal rigidities than with a popular alternative based on local-currency pricing. © 2000 Elsevier Science B.V. All rights reserved.

This paper develops a dynamic model of seigniorage in which economies' equilibrium paths reflect the ongoing strategic interaction between an optimizing government and a rational public. The model extends existing positive models of monetary policy and inflation by explicitly incorporating the intertemporal linkages among budget deficits, debt, and inflation. A central finding is that the public's rational responses to government policies may well create incentives for the government to reduce inflation and the public debt over time. A sufficiently myopic government may, however, provoke a rising equilibrium path of inflation and public debt.

IN AN IMPORTANT recent contribution, Persson, Persson, and Svensson (1987) (hereafter PPS) suggest that through careful restructuring of its nominal and real debt obligations, a government may be able to induce future governments to follow the monetary and fiscal policies that it regards as optimal today. The PPS argument builds on Lucas and Stokey's (1983) demonstration that in a special nonmonetary setting, the time inconsistency of optimal fiscal policy can be avoided through managing the term structure of real government obligations to the public. The basic idea of the PPS scheme for monetary economies is disarmingly intuitive: in addition to continually restructuring nominal and real debt obligations a la Lucas-Stokey, each government must ensure that the next government inherits a stream of nominal claims on the public whose present discounted value equals the stock of money. This equality, PPS argue, removes the incentive for surprise inflation or deflation, because such surprises would not affect the real net worth of the government. This note shows that the PPS prescription for avoiding time inconsistency, appealing as it is, is not generally sufficient. Even under the debt restructuring they recommend, optimal policy is likely to be time inconsistent. The main reason why their scheme fails is that the restrictions it imposes on government asset stocks satisfy first-order but not second-order conditions for an optimum. Because of the complex interactions between the current price level and future interest rates, a government can raise its objective function by moving several variables at once away from the levels planned by the previous government, even though price-level changes alone would not affect government net worth. We develop our argument using the model, notation, and equation numbers of PPS, to which the reader is referred for details. The maximization problem associated with

This paper investigates the long- and short-run neutrality of open-market monetary policy in a world of fixed exchange rates and imperfect substitutability between bonds denominated in different currencies. Using an illustrative portfolio-balance model, it shows that when the public discounts the future tax liabilities associated with the national debt and the central bank supports the exchange rate by trading non-interest-bearing foreign assets, open-market policy has a short-run effect, but no long-run effect, on the domestic price level and interest rate. When the foreign-exchange intervention assets earn interest that is rebated to and capitalized by the public, open-market policy loses even its short-run efficacy — the capital-account offset to monetary policy is complete.

ECONOMISTS HAVE RECENTLY begun to explore the effects of prospective regime changes on forward-looking variables. In an example inspired by Britain's return to the gold standard in 1925, Flood and Garber (1983) study the case in which an asset price (specifically, the exchange rate) floats freely until it reaches a pre-announced level, at which time the government intervenes to keep it fixed thereafter. They show how a first-stopping time methodology can be applied to their problem, but are unable to derive a closed-form solution using that mathematically cumbersome technique. In this paper we apply techniques of regulated Brownian motion to derive easy solutions for a large class of regime-switching problems, including the one posed by Flood and Garber (1983).2 The technical approach we use has several advantages over the alternatives. First, and most important, the method is both simple and helpful for understanding the intuition behind the mathematics. Second, it clarifies the economic similarities between Flood-Garber process switches and other types of stochastic regime change. Finally, the approach allows us to be precise about potential indeterminacies in asset prices that can crop up when policy makers do not fully specify how they intend to achieve their economic targets.3 The rest of the paper is structured as follows. In Section 2 below, we lay out a very general exchange-rate model. Section 3 contains solutions to several specific processswitching examples, and it also discusses how some formulations of future policy intentions may leave asset prices under-determined.

The purpose of this paper is two fold. First, to estimate, using structural methods, the extent to which capital flows undermined West German monetary policy during the Bretton Woods years 1960 to 1970 and second, to show that earlier reduced form estimates of the capital-account offset coefficient are tainted by simultaneity bias thanks to the Deutsche Bundesbank's systematic policy of sterilization, and so overestimate the true coefficient. The paper distinguishes between the short-run or one-quarter offset coefficient and the long-run coefficient implied by the full adjustment of all asset markets. An aggregative structural model German financial markets yields short-run coefficients between .50 and .65implying substantial Bundesbank control over the monetary base, at least in the short-run. A formal test for simultaneous-equations bias provides evidence that variations in domestic credit cannot be regarded as exogenous and that equations regressing capital flows on changes in domestic credit and other variables exaggerate the extent of the offset.

This paper is an empirical study of the Banco de Mexico's monetary policy during the 1970s. In particular, it studies the Mexican monetary equilibria and the extent to which capital mobility undermined monetary control. Estimates of a Banco de Mexico reaction function suggest that the Mexican central bank attempted to sterilize reserve flows through offsetting movements in domestic credit, at least over the second half of the decade. This finding suggests that estimates of the capital-account response to domestic credit expansion should be derived from a structural model, and we accordingly estimate an aggregative three-equation model of Mexican financial markets. The paper distinguishes between the short-run or one-quarter capital-account offset and a hypothetical long-run offset that would obtain under instantaneous asset-market adjustment. The model implies that, depending on the method of monetary expansion, between 30 and 50 percent of an expansion in domestic credit was offset by capital outflow in the same quarter. The implied long-run offsets range from 50 to 76 percent. These offset coefficients indicate that the Banco de Mexico's monetary control was exercised at a substantial cost in terms of reserve volatility.

This paper presents a long-run model of the open economy in a world of fixed exchange rates and imperfect substitutability between bonds denominated in different currencies. The model explicitly accounts for the wealth flow accompanying current-account imbalance and for the flow of interest payments associated with international lending. Both the dynamic and steady-state implications of the model are quite different from those of models that specify the capital account as a continuing flow responding to the level of interest rates. In particular, we find that when there exists outside government debt, open-market policy is not in general neutral in the long run. We also find conditions under which the central bank is able to hold the domestic price level constant in the face of an inflationary disturbance from abroad without exhausting, in the long run, its stock of domestic assets.

Simple techniques of regulated Brownian motion are used to analyze the behavior of the exchange rate when official policy reaction functions are subject to future stochastic changes. We examine exchange-rate dynamics in cases where the authorities promise (i) to confine a floating rate within a predetermined range, (ii) to peg the currency once it reaches a predetermined future level, and (iii) to unify a system of dual exchange rates. Similarities among these and several related examples of regime switching are stressed. We also discuss how stochastic regime changes can affect some standard statistical tests of hypotheses about exchange rates.

This paper develops a dynamic model of seigniorage in which economies' equilibrium paths reflect the ongoing strategic interaction between an optimizing government and a rational public. The model extends existing positive models of monetary policy and inflation by explicitly incorporating the intertemporal linkages among budget deficits, debt, and inflation. A central finding is that the public's rational responses to government policies may well create incentives for the government to reduce inflation and the public debt over time. A sufficiently myopic government may, however, provoke a rising equilibrium path of inflation and public debt.