Self-Oriented Monetary Policy, Global Financial Markets and Excess Volatility of International Capital Flows

43 Pages Posted: 25 Jan 2016  

Ryan Banerjee

Bank for International Settlements (BIS)

Michael B. Devereux

University of British Columbia (UBC) - Department of Economics; Centre for Economic Policy Research (CEPR)

Giovanni Lombardo

Bank for International Settlements (BIS)

Multiple version iconThere are 2 versions of this paper

Date Written: January 2016

Abstract

This paper explores the nature of macroeconomic spillovers from advanced economies to emerging market economies (EMEs) and the consequences for independent use of monetary policy in EMEs. We first empirically document the effects of US monetary policy shocks on a sample group of EMEs. A contractionary monetary shock leads a retrenchment in EME capital flows, a fall in EME GDP, and an exchange rate depreciation. We construct a theoretical model which can help to account for these findings. In the model, macroeconomic spillovers are exacerbated by financial frictions. We assess the extent to which domestic monetary policy can mitigate the negative spillovers from foreign shocks. Absent financial frictions, international spillovers are minor, and an inflation targeting rule represents an effective policy for the EME. With frictions in financial intermediation, however, spillovers are substantially magnified, and an inflation targeting rule has little advantage over an exchange rate peg. However, an optimal monetary policy markedly improves on the performance of naive inflation targeting or an exchange rate peg. Furthermore, optimal policies don't need to be coordinated across countries. Under the specific set of assumptions maintained in our model, a non-cooperative, self-oriented optimal policy gives results very similar to those of a global cooperative optimal policy.

Keywords: International spillovers, Local Projections, Capital flows, Financial intermediaries, Monetary policy

JEL Classification: E3, E5, F3, F5, G1

Suggested Citation

Banerjee, Ryan and Devereux, Michael B. and Lombardo, Giovanni, Self-Oriented Monetary Policy, Global Financial Markets and Excess Volatility of International Capital Flows (January 2016). BIS Working Paper No. 540. Available at SSRN: https://ssrn.com/abstract=2720436

Ryan Banerjee (Contact Author)

Bank for International Settlements (BIS) ( email )

Centralbahnplatz 2
Basel, Basel-Stadt 4002
Switzerland

Michael B. Devereux

University of British Columbia (UBC) - Department of Economics ( email )

997-1873 East Mall
Vancouver, BC V6T 1Z1
Canada
604-822-2542 (Phone)
604-946-6271 (Fax)

Centre for Economic Policy Research (CEPR)

77 Bastwick Street
London, EC1V 3PZ
United Kingdom

Giovanni Lombardo

Bank for International Settlements (BIS) ( email )

Centralbahnplatz 2
Basel, Basel-Stadt 4002
Switzerland

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