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CAPITAL MOBILITY AND MONETARY POLICY

There are similar limits to national sovereignty with regard to monetary policy. In a small open economy, money supply is at least partly exogenous as a result of unrestricted financial flows. Even under a freely floating exchange rate and inflation-targeting, the room for manoeuvre of national monetary policy is limited and determined by political and economic tolerance of exchange rate fluctuations. ‘Leaning against the winds’ of international financial markets usually leads to either appreciation or depreciation of the domestic currency. Excessive appreciation deteriorates the competitiveness of domestic producers while excessive depreciation may have negative pass-through effects on inflation, increase the domestic currency value of foreign-currency-denominated liabilities, and may trigger a flight from the domestic currency, especially in countries with fresh memories of high inflation or hyperinflation, insufficiently credible national monetary policy and high actual dollarization or euroization. To respect these limitations the central bank’s interest rate decisions must take into account international financial market trends and cannot deviate too much from them.

On the other hand, changes in interest rates on international financial markets are determined by the monetary policy decisions of central banks of major advanced economies, in particular the US Federal Reserve Board (Fed). The global integration of financial markets and the role of the US dollar as the number one international reserve and transaction currency leads to a situation when the Fed’s monetary policy decisions have an economic impact far beyond its formal jurisdiction (see Ghosh et al., 2012). To a lesser extent, this also relates to the euro and the Japanese yen.

In the 2000s the Fed’s monetary policy went through two large-scale easing cycles: in the early 2000s, following the dot.com recession and the 9/11 terrorist attack; and since summer 2007 when the subprime mortgage crisis erupted. Monetary easing was determined by the Fed’s perception of US domestic economic conditions and remained in line with its formal legal mandate. However, in both instances monetary easing contributed to a huge expansion of international liquidity and net private financial flows to emerging-market and developing economies, and their subsequent volatility as demonstrated in Figure 7.1.

Monetary policy decisions in major advanced economies put other central banks, including those in emerging-market and developing economies, in an uneasy position. Because of their limited ability to ‘lean against the wind’ (see above) they must follow decisions of major players even if macroeconomic conditions in their own countries differ substantially. Very often what is perceived by central banks of smaller countries as external shocks (increase in commodity prices or sudden changes in country risk perception) is a by-product of monetary decisions of major central banks.

Solving this conflict would require broadening the actual mandate and goal function of the Fed and other central banks which issue international reserve currencies. They should pay more attention to international spillovers of their monetary policy decisions (see Ostry et al., 2012 on source-country policies). This is not a matter of policy altruism but a well- recognized interest of their own economies. In many instances negative externalities will come back, as a boomerang, to a given monetary authority, even if this happens with a certain time lag. They may have a form of higher commodity prices, financial bubbles and BoP crises in other economies but affect the home country’s financial sector, and so on.

More generally, systematic global monetary policy coordination would help to decrease a one-way dependence of smaller central banks in respect to key players. However, this is not an easy goal to achieve, at least not soon, for at least two fundamental reasons.

Firstly, any attempt at collective action at a supranational level compromises national sovereignty. In the case of monetary policy coordination the differences in the legal mandates of individual central banks, some of them being exclusively responsible for price stability (the European Central Bank, ECB), others (such as the Fed) also obliged to follow output or employment goals and specific guarantees of their independence anchored in national legal systems, may create an additional obstacle.

Secondly, even if the political and legal obstacles were overcome, the attempt at global monetary policy coordination would face a shortage of macroeconomic theory providing conceptual and analytical tools for such coordination. For the time being there is no conceptual clarity on how to define and measure global money supply or global liquidity (see Chen et al., 2012 for an attempt to measure global liquidity), which factors and mechanisms determine changes in global money supply (however defined), what is the role of cross-country money multipliers under various exchange rate regimes, and so on. All the theoretical models of monetary policy (such as the Taylor rule) analyse its determinants, tools and consequences within a single national economy. There is no global monetary model, nor are there even sufficient external spillovers in national models.

Practical attempts at global macroeconomic policy coordination undertaken so far within the Multilateral Consultation framework of the International Monetary Fund (IMF) (see IMF, 2007b) and G-20 (see G-20, 2012, paragraph 7) have focused mainly on current account imbalances and their reduction through greater nominal exchange rate flexibility. As explained above, such an approach is based on an analytical framework and a set of assumptions typical for economies with restricted capital accounts, and targets secondary symptoms of macroeconomic distortions rather than their primary causes.

 
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