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December 5, 2007

Michael Woodford: Globalization and Monetary Control

Another paper from Michael Woodford. In this one, he asks if globalization means that the Fed will lose the ability to influence inflation:

Globalization and Monetary Control, by Michael Woodford, NBER WP 13329, August 2007: Abstract 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... 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.

What are the three factors that potentially change the IS, LM, and AS curves?

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 control domestic aggregate demand, this might not allow any control over domestic inflation.

And he finds that:

I take up each of these possibilities, by discussing the effects of openness (of goods markets, of factor markets, and of financial markets) on each of these three parts of a "new Keynesian" model of the monetary transmission mechanism. I first consider each argument in the context of a canonical open-economy monetary model..., and show that openness need not have any of the kinds of effects that I have just proposed. In each case, I also consider possible variants of the standard model in which the effects of globalization might be more extreme. These cases are not always intended to be regarded as especially realistic, but are taken up in an effort to determine if there are conditions under which the fear of globalization would be justified. Yet I find it difficult to construct scenarios under which globalization would interfere in any substantial way with the ability of domestic monetary policy to maintain control over the dynamics of domestic inflation.

It is true that, in a globalized economy, foreign developments will be among the sources of economic disturbances to which it will be appropriate for a central bank to respond, in order for it to achieve its stabilization goals. But there is little reason to fear that the capacity of national central banks to stabilize domestic inflation, without having to rely upon coordinated action with other central banks, will be weakened by increasing openness of national economies.

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