mr. meyer focuses on the effect of globalization on the conduct of us monetary policy remarks by mr. laurence h. meyer, a member of the board of governors of the us federal reserve system, before the institute for global management and research, school of business and public management, the george washington university, washington, d. c., on 14 / 10 / 97. world trade has increased much faster than world output over the last 30 years and international capital flows have expanded at a still more rapid pace. as a result, forecasting and modeling the national economic developments and the conduct of domestic policy has increasingly required more careful attention to the global context. my focus is on how globalization has affected the conduct of u. s. monetary policy. i begin by documenting the trend toward increased openness of the u. s. economy. with that background in place, i turn to the implications of increased openness for the conduct of u. s. monetary policy. the views i present here about the conduct of monetary policy are my own. they should not be interpreted as official policy positions of the board of governors or the fomc. some of the questions that i address along the way are : does an open economy introduce either new objectives or new instruments for monetary policy? how does an open economy affect the monetary policy transmission mechanism? does the rapid growth in cross - border capital flows limit or even eliminate the ability of domestic monetary policy to affect domestic interest rates? how does u. s. monetary policy affect economic conditions in other countries? how does globalization affect the cyclical properties of the u. s. economy, the inflation process, and longer - term trends in the economy? my conclusion is that, while the increasing openness has resulted in some important changes to how the u. s. economy operates, it has not fundamentally altered the determination of output and inflation, introduced new objectives of monetary policy, or offered new instruments to pursue those objectives. nevertheless, it has importantly affected the monetary policy transmission mechanism and increasingly subjected the domestic economy to the effects of changes in economic conditions abroad. documenting the trend toward increased openness of the u. s. economy the increased openness has two dimensions - - expanded trade in goods and services and expanded cross - border capital flows. a related indicator of openness is the volume of foreign exchange transactions, since both goods and financial asset transactions typically are preceded by currency conversions. u. s. trade in goods and services has increased about twice as fast as the growth

inversely related to u. s. interest rates. evidence suggests that the response of net exports to interest rates ( via exchange rates ) has become larger over time. the open economy version of the monetary policy transmission mechanism involves three steps : from u. s. interest rates to nominal exchange rates ; from nominal exchange rates to the absolute and relative prices of imports and exports ; and from the prices of imports and exports to the real volumes of imports and exports and domestic prices. from u. s. interest rates to the exchange rate we begin with the link between interest rates in the u. s. and exchange rates. a policy - initiated increase in u. s. short - term rates would, as noted above, generally result in higher u. s. long - term interest rates. at initial levels of foreign interest rates and equity prices, the movement in u. s. rates would make dollar - denominated assets more attractive compared to foreign currency - denominated assets, resulting in shifts in asset demands and either incipient or actual cross - border capital inflows to the u. s. and outflows from foreign economies. these shifts result in an appreciation of the dollar. indeed, the single most important determinant of short - term movements in exchange rates is the change in real interest rate differentials across countries. a 1 % point increase in u. s. long - term ( 10 - year ) interest rates, with unchanged foreign rates, will typically induce a 10 % increase in the u. s. trade - weighted exchange rate. after the initial jump in the dollar, there will be an expectation of a decline in the dollar by about 1 % each year for the next 10 years. the result of the rise in the dollar and the expectations of gradual reversal is what is referred to as international interest rate parity. the holding period yields of u. s. and foreign assets, each denominated in their home currency, are thereby equated, eliminating the incentive for further changes in asset demands or capital flows. that is, the higher interest rate yield on u. s. assets ( measured in dollars ) is just offset by the expected depreciation in the value of the asset, measured in the foreign currency. this is the mechanism by which holding period yields are equated across countries via international capital flows. by the end of the 10 - year period, according to this framework, both interest rates and exchange rate would have returned to their original