Good Policies or Good Luck? New Insights on Globalization and the International Monetary Policy Transmission Mechanism

Abstract

The open-economy dimension is central to the discussion of the trade-offs that monetary policy faces in an increasingly integrated world. I investigate the monetary policy transmission mechanism in a two-country workhorse New Keynesian model where policy is set according to Taylor (in: Carnegie-Rochester conference series on public policy, vol 39, pp. 195–214, 1993) rules. I find that a common monetary policy isolates the effects of trade linkages on the cross-country dispersion alone, and that the establishment of a currency union as a means of deepening policy integration may lead to indeterminacy. I argue that the common (coordinated) monetary policy equilibrium is the relevant benchmark for policy analysis showing that open economies tend to experience lower macro volatility, a flatter Phillips curve, and more accentuated trade-offs between inflation and slack. Moreover, the trade elasticity often magnifies the effects of trade integration (globalization) beyond what conventional measures of trade openness would imply. I also discuss how other features such as the strength of a common anti-inflation bias in policymaking, technological diffusion across countries, and the sensitivity of labor supply to real wages influence the quantitative effects of policy and openness in this context. Finally, I conclude that these theoretical predictions are largely consistent with the stylized facts of the Great Moderation.