lecture 10- costs of financial globalisation - trilemma or dilemma

Question 1

what is the mundellian trilema?

Answer 1

policy makers in an open economy would prefer their monetary policy to achieve three main features: exchange rate stability, freedom of financial flows and monetary policy autonomy. however the policy makers can only achieve two of the three at the same time

Question 2

what is the interest parity condition when capital markets are fully open and there are no impediments to financial transactions across borders?

Answer 2

i(UK)= i(US) + [E(e(£$))-e(£$)]/e(£$)

Question 3

what is the interest parity condition under fixed exchange rates with free exchange rate?

Answer 3

i(UK)=i(US) as the expected exchange rate E(e(£$) is equal to the exchange rate e(£$)

Question 4

what is the key implication of the free capital with fixed exchange rate?

Answer 4

the short-term interest rate in the UK, which is the conventional instrument of monetary policy, would be completely tied to the short-term interest rate set in the US so loss of monetary policy independence

Question 5

give examples of the trilema in history?

Answer 5

GOLD STANDARD PERIOD(1870-1914): characterised by fixed exchange rate and capital mobility (no monetary independence)
BRETTON WOODS PERIOD (1944-1971): characterised by fixed exchange rates and monetary policy independence (no capital mobility)
POST 1971- period: characterised by monetary policy independence and capital mobility with no fixed exchange rate

Question 6

how do we test for the validity of the trilema hypothesis?

Answer 6

obstfeld and Taylor (2004) have looked at whether the short term interest rates follows more closely the interest rate of the base country in countries with fixed exchange rates throughout history. expecting the interest rate were equalised with the base country is probably unrealistic. the base rate is taken to be the UKS for the gold standard period, the US for the bretton woods and the dominant currency in the regions for the post bretton woods period
They estimate the following regression:
∆R_(it)= A + B*∆R_(bit) + B(2)PEG_(it)∆R_(bit) + u_(it)
R_(it) is the local interest rate of country i at time t
R_(bit) is the interest rate of the base country for country i at time t
PEG is a dummy variable that measures whether the country has fixed exchange rate or not

Question 7

what were obstfield and Taylors findings on the trilema?

Answer 7

▪ During the Bretton Woods period, there was no response of interest
rates to US interest rates (no capital mobility)
▪ During the Gold Standard and the post-1971 period (capital mobility), interest rates tend to follow the base interest rates, but the effect is much stronger for countries with pegged exchange rates.
▪ The dependence on the foreign interest rate is more pronounced during
the Gold Standard (greater credibility of exchange rate commitments during the Gold Standard or more capital controls in the modern era?)
▪ In a nutshell, the exchange rate regime matters for monetary policy independence in a world of capital mobility.

Question 8

what was rey (2015) challenge to the trilema?

Answer 8

Short-term interest rates are not the only relevant variable when assessing countries’ monetary policy independence in a world of free capital mobility.

Question 9

what were the key findings of the global financial crisis?

Answer 9

A global factor explains over 20% of variations in the price of risky assets across the world.
There exist a significant global factor also in capital flows (not just asset prices)!

Question 10

what is the global factor negatively correlated with?

Answer 10

The global factor is negatively correlated with the VIX, which is an index about aggregate volatility (“market fear” or risk aversion) in the economy.
When the VIX is low (low risk aversion), asset prices inflate and there is more credit creation.

Question 11

what is the key contribution of miranda-agrippino and rey (2020)

Answer 11

they show that the global financial cycle is heavily influenced by us monetary policy
following a US monetary policy tightening:
- private liquidity contracts/world financial conditions tighten
- dollar appreciates
- global asset prices and global capital flows contract on impact while the VIX spikes up

Question 12

what are the policy implications that arise from monetary policy and the global financial crisis?

Answer 12

1) Monetary policy in the US should care about financial spillovers to
the rest of the world/internalise them.
2) Macroprudential policy or capital controls are needed to avoid extreme episodes (e.g. relaxing controls when credit is low and imposing controls when availability of credit is high)

Question 13

what are the critism about the global financial crisis and monetary policy?

Answer 13

The presence of a global financial cycle which is heavily impacted by the
US monetary policy affecting floaters and non-floaters alike does not
necessarily mean that the exchange rate regime is irrelevant
Although countries with flexible exchange rate cannot fully insulate
against foreign shocks, exchange rate flexibility is still an “extra degree of
freedom” or one less policy objective to worry about!
Monetary policy’s key concerns are inflation and employment, while
financial stability risks should be address by macro-prudential policy etc.
not monetary policy

Question 14

what was Obstfeld, Ostry and Qureshi (2019) challenge Rey’s results?

Answer 14

Obstfeld, Ostry and Qureshi (2019) challenge Rey’s results and show
that the transmission of global financial shocks is magnified under
fixed exchange rate regime. In particular, they show that the response of domestic financial
variables (domestic credit growth, prices of risky assets and banking
system leverage) to global financial condition (VXO index) is stronger
for countries with a fixed exchange rate.

Question 15

what is the summary on the trilema?

Answer 15

The conventional wisdom was that countries with a flexible exchange
rate regime are (more) insulated against foreign shocks/able to carry out
an independent monetary policy if they open the capital account
(Trilemma)
▪ Rey challenged this view and showed that US monetary policy affects
credit conditions (asset prices/capital inflows) of developing and
emerging markets’ economies independently from their exchange rate
regime.
▪ Because of this, even countries with a flexible exchange rate are not
able to fully control domestic economic/financial conditions via
domestic monetary policy (financial globalisation is quite costly then!).
However, Obstfeld and Taylor (2004) showed that interest rates of
periphery countries were still influenced by the interest rate of the
centre countries under flexible exchange rate regimes, but only to a
less extent than countries with a fixed exchange rate regime.
▪ Obstfeld et al. (2019) paper shows that the same applies for domestic
financial variables (the interest rate is not the only variable to look at,
especially in a world with unconventional monetary policy etc.):
countries with a fixed exchange rate respond more to global financial
conditions.
▪ Monetary policy frameworks are not being updated to reflect
financial spillovers (so far!).