Working Paper: NBER ID: w21737
Authors: Ryan Banerjee; Michael B. Devereux; Giovanni Lombardo
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 the- oretical 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 ef- fective 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: Monetary Policy; Emerging Markets; Capital Flows; Financial Frictions
JEL Codes: E3; E5; F3; F5; G1
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Contractionary US monetary policy shock (E49) | Retrenchment in EME capital flows (F32) |
| Contractionary US monetary policy shock (E49) | Decrease in EME GDP (E20) |
| Contractionary US monetary policy shock (E49) | Exchange rate depreciation (F31) |
| Contractionary US monetary policy shock (E49) | Rise in domestic policy rates in EMEs (E52) |
| Rise in domestic policy rates in EMEs (E52) | Decline in capital inflows to EMEs (F32) |
| Contractionary US monetary policy shock (E49) | Rise in interest rate spreads within EMEs (F65) |
| Rise in interest rate spreads within EMEs (F65) | Decline in capital inflows to EMEs (F32) |
| Contractionary US monetary policy shock (E49) | Impact on asset prices in EMEs (F65) |
| Contractionary US monetary policy shock (E49) | Amplification effect due to financial frictions (E44) |
| Differences in responses between inflation targeting rule and exchange rate peg (F31) | Minimal differences (F12) |