Paper Series Globalization and Monetary Control

It has recently become popular to argue that globalization has had or will soon have dramatic consequences for the nature of the monetary transmission mechanism, and it is sometimes suggested that this could threaten the ability of national central banks to control inflation within their borders, at least in the absence of coordination of policy with other central banks. In this paper, I consider three possible mechanisms through which it might be feared that globalization can undermine the ability of monetary policy to control inflation: by making liquidity premia a function of “global liquidity” rather than the supply of liquidity by a national central bank alone; by making real interest rates dependent on the global balance between saving and investment rather than the balance in one country alone; or by making inflationary pressure a function of “global slack” rather than a domestic output gap alone. These three fears relate to potential changes in the form of the three structural equations of a basic model of the monetary transmission mechanism: the LM equation, the IS equation, and the AS equation respectively. I review the consequences of global integration of financial markets, final goods markets, and factor markets for the form of each of these parts of the monetary transmission mechanism, and find that globalization, even of a much more thorough sort than has yet occurred, is unlikely to weaken the ability of national central banks to control the dynamics of inflation. ∗Prepared for the NBER conference on International Dimensions of Monetary Policy, Girona, Spain, June 11-13, 2007. I would like to thank Pierpaolo Benigno, Pierre-Olivier Gourinchas, David Romer, Argia Sbordone and Lars Svensson for helpful discussions and comments on earlier drafts, Luminita Stevens for research assistance, and the (U.S.) National Science Foundation for research support through a grant to the National Bureau of Economic Research. Concern has recently been expressed in a variety of quarters that the problems facing central banks may be substantially complicated by the increasing globalization of goods markets, factor markets, and financial markets in recent years. Some of the more alarmist views suggest that the very ability of national central banks to materially influence the dynamics of inflation in their countries through monetary policy actions may be undermined by globalization. According to such accounts, the recently observed low and stable inflation in many parts of the world should be attributed mainly to favorable (and likely transient) global developments rather than to the sound policies of central banks in those parts of the world; and rather than congratulating themselves on how skilled they have become at the conduct of monetary stabilization policy, central bankers should instead live in dread of the day when the implacable global market forces instead turn against them, making a return of inflation all but inevitable. In this paper I consider a variety of reasons why globalization might be expected to weaken the control of national central banks over inflation within their borders. These correspond to three distinct aspects of the transmission mechanism for monetary policy: the link between central-bank actions and overnight nominal interest rates (in a conventional 3-equation model, the extent to which it is possible for central-bank policy to shift the “LM curve”); the link between real interest rates and the balance between saving and investment in the economy (described by the “IS curve”); and the link between variations in domestic real activity and inflation (described by the “AS curve”). On the one hand, it might be thought that in a globalized world, it is “global liquidity” that should determine world interest rates rather than the supply of liquidity by a single central bank (especially a small one); thus one might fear that a small central bank will no longer have any instrument with which to shift the LM curve. Alternatively, it might be thought that changes in the balance between investment and saving in one country should matter little for the common world level of real interest rates, so that the “IS curve” should become perfectly horizontal even if the LM curve could be shifted. It might then be feared that loss of control over domestic real interest rates would eliminate any leverage of domestic monetary policy over domestic spending or inflation. Or as still another possibility, it might be thought that inflation should cease to depend on economic slack in one country alone (especially a small one), but rather upon “global slack”; in this case the AS curve would become horizontal, implying that even if domestic monetary policy can be effectively used to