Global Transmission of Interest Rates

8/14/2019 Global Transmission of Interest Rates

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Chapter 11

Global Transmission of Interest Rates and Monetary Independence

All systems either of preference or of restraint, therefore, being thus

completely taken away, the obvious and simple system of natural liberty

establishes itself of its own accord. Every man, as long as he does not

violate the laws of justice, is left perfectly free to pursue his own interest

his own way, and to bring both his industry and capital into competition

with those of any other man, or, order of man.

[Adam Smith in An Inquiry into the Nature and Causes

of the Wealth of Nations ]

The choice of exchange rate regime fixed , floating, a combination of two or a

pegged one has been always a favorite question in international macroeconomics.

According to the prevalent view, there are two principal advantages in a fixed exchangerate regime and these are: ( i) reduced transaction cost and exchange rate risk, and, (ii) a

credible nominal anchor for monetary policy. The first facilitates international trade and

investment of foreign capital. The second helps in the stability off the domestic currency.

The flexible exchange rate has the unique advantage that it allows the country to pursue independent monetary policy. There are other advantages also. In case of

independent currency the government retains the seignorage and second, floating ofcurrency can lead to a smooth adjustment to real external shocks even when pricefrictions exist in the economy. Of course the first one, i.e., monetary independence is very

important and we take up this issue now.

Under flexible exchange rate the monetary independence is maintained and the

monetary authority enjoys the advantage of discretion rather than the rules. Suppose the

economy is hit by a disturbance in the form of a shift of worldwide demand away from

the goods the country produces. In such a situation the government would like to respondso that the country can avoid a potential recession. The authority can go for a monetary

expansion and depreciation of the domestic currency. This will stimulate the demand for

domestic commodities and help the economy return to the desired level of output. Thisadjustment could not have been achieved under a fixed exchange rate regime when

monetary policy would have been powerless.

Under a pegged exchange rate and unrestricted capital flows, the traditional

literature argues that domestic interest rate cannot be set independently, as it should keep

pace with the interest rate of the currency to which the domestic currency is pegged. Butunder a flexible exchange rate regime, domestic interest rate is less sensitive to changes

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in the foreign interest rates. Again the countries with intermediate exchange rate regimes

should show less sensitivity to changes in international interest rates than countries

with firm pegged rates.

Against the traditional views an alternative view stated by Calvo and Reinhart

(2001, 2002) , and Hausmann, Panizza and Stein ( 2001) holds that there exists a fear offloating that prevents countries with de jure flexible regime from allowing their

exchange rates to move freely. This view holds that factors like exchange rate pass

through, lack of credibility and foreign currency liability prevent countries frompursuing an independent monetary policy irrespective of the nature of exchange rate

regime. The result is that many countries with floating exchange rate are following the

monetary policies of major- currency countries like the USA or some EU countries. It is

also suggested that the interest rate may be more sensitive to the US interest rate indeveloping countries with flexible rates than in countries with fixed rates, as the flexible

rate countries suffer from having to pay risk premium ( for currency risk and default

risk) and this premium is sensitive to international interest rates.

The main question is whether floating exchange rate regime do facilitate to follow

an independent monetary policy in the sense that domestic interest rates in such countriesare less sensitive to the changes in international interest rates. The empirical evidence

on this issue is scarce and not decisive. It is also observed that the developing countries

do not stick to a particular exchange rate regime and they often change the nature of the

regime in response to both internal and external shocks.

There are several factors that determine the extent to which domestic and foreign

interest rate will move together. First, the degree of financial integration of the domesticeconomy into the world markets moulds the domestic capital market. If there are barriers

to international capital flows, the response of the local interest rate to changes in the

international rates will be less. This will allow the monetary authorities in countries tomaintain different interest rates even under fixed exchange rate regime.

Second, the degree of real international integration influences the co-movement ofdomestic and foreign interest rates. The movement of the two rates will be close if the

business cycles in two countries are highly synchronized and the integration of the capital

markets in two countries are near perfect with no restriction on capital mobility.

11.1. Financial Integration and Capital Mobility

Many economists now recognize the relentless trend toward globalization and

increasing capital mobility. Empirical studies have shown that since the 1980s there

have been a growing degree of capital market integration all over the world and capitalmobility has increased tremendously. Many experts believe that these trends are largely

inevitable and irreversible too. Because, these are partly driven by new innovations of

information technology and better communications, and partly because policy makers

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are increasingly convinced about many benefits of regulatory changes that foster

financial integration. So capital mobility is irreversible.

The changed world scenario has some important implications. The more openness

of the economy ad open environment imply that changes in monetary policy involve a

somewhat different transmission mechanism than what it used to be in earlierrelatively closed regime. For example, the more integrated the economy, the more

quickly do divergent policies affect financial markets and capital flows. Also foreign

exchange rate may play an increasing important role in transmitting changes in monetarypolicy to the macro economy. Thus exchange rate movement may contain more useful

information about the changes in domestic monetary policies compared to the earlier

times when the world did not experience so much financial integration.

11.2. The Policy Trilemma

The changed world situation of increased capital mobility has placed constraintson the implementation of domestic monetary policy and this Obstfeld ( 1998) describes

as follows:

The limitations that open capital market place on exchange rate and monetary

policy are summed up by the ideas of the inconsistent trinity or .. the open

economy trilemma .. that is, a country cannot simultaneously maintain fixed

exchange rates and open capital markets while pursuing a monetary policy

oriented toward domestic goals. Governments may choose only two of the above.

[ Obstfeld, 1998: p. 14-15]

We see the consensus above about unrestricted capital mobility, and if that isirreversible and given, the policy choices circumscribed by the above trilemma are

limited. For the governments of the developing countries the policy choices are now

between flexible exchange rate / domestic monetary policy goal ( say, inflation targeting)

regimes and fixed exchange rate / no domestic goal regimes. If policy makers go forfixed exchange rate, they lose control of the exchange rate. If they peg the interest rate,

they cannot control the exchange rate. Some economists suggest that the choice in recent

time has moved in favour of flexible exchange rate / domestic monetary policy

alternative, which boils down to a de facto informal inflation targeting regime(Eichengreen, 1996). This also goes well with the contemporary political economy of

many developing countries as the authority can exercise control on the domesticmonetary policies.

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11.3. US Dollar as International Currency

There has been another trend in the international arena and it is that US dollar hasappeared in a new role apart from its Bretton Woods role of international currency. Many

newly emerging market economies and some Latin American countries have started using

dollar as the official currency. US dollar has replaced the domestic currency. Also inmany countries people are informally holding dollars. Situation is such that foreigners are

holding a large percentage of US dollar currency outside the USA and the amount is no

less than 50 per cent ( Porter and Judson, 1996). This induces Robert Mundell to state:

The need for an international unit of account for purposes of international

trade and finance was just as great as ever, and the increased uncertainty

associated with flexible exchange rates increased, rather than eliminated

the need for international reserve assets.. The dollar remained the principal

international monetary reserve ( in the 1980s and 1990s). The enhanced role ofthe dollar under flexible exchange rate was reflected in the rapid expansion of

dollar reserves which has more than kept pace with the growth of trade.

[Mundell, 1994; p.12 ].

Thus dollar continues to provide the principal function of international money and

so remains the dominant international key vehicle and reserve currency. The use of USdollar as international currency suggests that there remains an important demand for the

services of international currency, i.e., continued demand for a money for other monies.

Given this global demand, the suppliers of this global currency, the Federal Reserve ofthe United States has a responsibility of adjusting the global supply of US dollar as and

when demands for dollar changes. This will promote international stability. But it has

another implication. When the Federal Reserve of the USA tightens policy and as a resultmoney supply gets restricted even globally, other central banks in countries that are using

dollar should follow the Federal Reserve. Also the use of dollar as international reserve

boils down to the role of Federal Reserve as the international lender of last resort. All

these imply that monetary policy in the developing countries that use dollar as thecurrency becomes dependent on the policy of the Federal Reserve of America.

A large body of empirical literature suggests that changes in the monetary policyof Federal Reserve can have significant impact on the policy of foreign countries, and on

the global economy. There are evidences that international capital flows, recent crisis in

the international banking and currency markets and choice of exchange rate regimes may

have been influenced by the policy changes of the Federal Reserve ( Calvo, 1996).

Recent research on the choice of exchange rate regime has also revealed that US

monetary policy has significant impact on the foreign interest rates. This is evident whenthe developing countries adjust their interest rates in response to the interest rate changes

by the Federal Reserve. This has been seen in times off Russian devaluation in 1998, in

times of Asian currency crisis and also Mexican crisis.

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Table:: Countries and Their Exchange Rate Regimes

Country Period Exchange Rate Regime

Argentina March 1991 onwards Peg to US dollar

Australia December 1983 onwards independently floating

Canada January 1975 onwards independently floatingChile January 1999 onwards crawling band

Columbia January 1999 onwards crawling Band

Denmark*** Jan 1972 --- Mar. 1999 Limited flexibility with respect to a

Cooperative arrangement ( LFCA)

Ecuador January 99 onwards crawling band

Egypt January 1997 onwards managed floating

Finland Oct 1996Mar 99 LFCA

Germany April 1973March 99 LFCA

Greece March 98 March 99 LFCA

Hong Kong December 1990 onwards Peg to US dollar

India August 1994 onwards managed floating

Ireland Jan 1979- Mar 99 LFCA

Israel January 1999 onwards crawling band

Italy Oct 1996- March 99 LFCA

Japan January 1973 onwards independently floating

South Korea December 1997 onwards independently floating

Mexico December 1997 onwards independently floatingNetherlands Jan 1972- Dec 1998 LFCA

New Zealand March 1985 onwards independently floating

Norway May 1994 onwards managed floating

Portugal April 1992- Mar 99 LFCA

Singapore July 1987 onwards managed floating

Spain June 89 March 99 LFCA

Sweden Nov 1992 Mar 99 independently floating

Thailand July 1998 onwards independently floatingUnited Kingdom July 1992 0nwards independently floating

Venezuela January 1999 onwards crawling band

Note:: *** means countries against which LFCA are written are countries who have

joined the European Union, and at present their currency is Euro, and it is independently

floating.

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The evidences indicate that the changes in the US monetary policy affect financial

markets in the developing countries through different transmission channels. Thesefurther suggest that international financial markets are becoming more integrated, and the

interest rates in the developing countries are becoming more sensitive to the interest rate

changes in the United States. This is true irrespective of different exchange rate regimes.

As seen in the table above for many developing countries US dollar has become a

reference currency. Not only that, there has been a high degree of volatility among thethree principal currencies of the world - US dollar, yen and Euro. The exchange rate of

both yen and Euro vis--vis dollar has become volatile and that has created problem for

the stability of exchange rate of many developing countries. The question now is whether

the three monetary area-- USA, Japan and European Union should initiate policies tostabilize the exchange rates as mentioned. A recent study cautions that in case the three

currencies are stabilized, that is not a sure guarantee for the stability of the developing

countries ( Reinhart & Reinhart, 2002).

For the newly emerging market economies US dollar has been the de jure or at

least de facto medium of exchange. This type of dollarization has other implications thatwe have covered on other chapters. What is relevant here is that the central banks in these

countries can not exercise an independent monetary policy. Also the monetary policy

followed by the Federal Reserve has various transmission channels that affect the

interest rate policy of not only the new market economies but other developing countriesas well who have pegged their currencies to US dollar.

It has been enquired in the literature whether the transmission of international interestrate affecting the changes of the local rates are influenced by the type of exchange rate

regimes ( Frankel et al, 2001). In this debate the issue of monetary independence has

played an important role. Supporters of independent- floating exchange rat regime arguethat countries adopting free float would be able to pursue their own monetary policy

goals. This strategy has been questioned by the proponents of the fixed exchange rate

regime (hard peg) regarding its feasibility of it in face of high international capitalmobility. This refers to the policy trilemma as we discussed in the beginning of this

chapter.

Empirical evidence suggests that in the 1990s all types of exchange rate regimes

showed high degree of sensitivity of local interest rates to the change in the internationalinterest rate. This is particularly true with full transmission in case of smaller countries.

The big industrial countries like Canada and Australia have experienced less than one

transmission rate (Frankel et al, 2001). Only major exception is the countries belongingto European Union, as this group in the 1990s has shown interest rate convergence to the

German interest rate. The EU countries have shifted from the US monetary area to the

DM- EU monetary area. But here also the convergence of the two principal rates may notbe far away.

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Global Transmission of Interest Rates