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 exchange rate 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 of currency can lead to a smooth adjustment to real external shocks even when price frictions 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 respond so 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. This adjustment 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. But under a flexible exchange rate regime, domestic interest rate is less sensitive to changes


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 of floating” 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 from pursuing 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 in developing 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 countries are 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 domestic economy 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 to maintain different interest rates even under fixed exchange rate regime. Second, the degree of real international integration influences the co-movement of domestic 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 capital mobility 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


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 earlier relatively 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 monetary policy 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 constraints on 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 is irreversible 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 for fixed 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 domestic monetary policies.


11.3. US Dollar as International Currency There has been another trend in the international arena and it is that US dollar has appeared 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 in many 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 of the 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 US dollar 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 of the 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 result money 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 the currency becomes dependent on the policy of the Federal Reserve of America. A large body of empirical literature suggests that changes in the monetary policy of 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 when the 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.


Table:: Countries and Their Exchange Rate Regimes Country Argentina Australia Canada Chile Columbia Denmark*** Ecuador Egypt Finland Germany Greece Hong Kong India Ireland Israel Italy Japan South Korea Mexico Netherlands New Zealand Norway Portugal Singapore Spain Sweden Period March 1991 onwards December 1983 onwards January 1975 onwards January 1999 onwards January 1999 onwards Jan 1972 --- Mar. 1999 January 99 onwards January 1997 onwards Oct 1996—Mar 99 April 1973—March 99 March 98 –March 99 December 1990 onwards August 1994 onwards Jan 1979- Mar 99 January 1999 onwards Oct 1996- March 99 January 1973 onwards December 1997 onwards December 1997 onwards Jan 1972- Dec 1998 March 1985 onwards May 1994 onwards April 1992- Mar 99 July 1987 onwards June 89 – March 99 Nov 1992 –Mar 99 Exchange Rate Regime Peg to US dollar independently floating independently floating crawling band crawling Band Limited flexibility with respect to a Cooperative arrangement ( LFCA) crawling band managed floating LFCA LFCA LFCA Peg to US dollar managed floating LFCA crawling band LFCA independently floating independently floating independently floating LFCA independently floating managed floating LFCA managed floating LFCA independently floating

Thailand July 1998 onwards independently floating United 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.


The evidences indicate that the changes in the US monetary policy affect financial markets in the developing countries through different transmission channels. These further 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 the three principal currencies of the world - US dollar, yen and Euro. The exchange rate of both yen and Euro vis-à-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 to stabilize 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 that we 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 countries as well who have pegged their currencies to US dollar. It has been enquired in the literature whether the transmission of international interest rate 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 argue that 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 capital mobility. 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 international interest 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 belonging to 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 not be far away.