Abstract
Between 2002 and 2006, the Federal Reserve set interest rates significantly below the rates suggested by well-known monetary policy rules. There is a growing body of research suggesting that this helped fuel an excess of liquidity in the U.S. that contributed to the 2008 worldwide financial crash. It is less well known that a number of other central banks also lowered interest rates during this period. An important question, then, is what role the Federal Reserve played in influencing other central banks to alter their own monetary policies, which could have magnified the Fed’s actions in creating global liquidity. This paper addresses the issue by showing how spillovers in central bank behavior occur in theoretical rational expectations models. It then establishes empirically how U.S. monetary policy actions affect the actions of other major central banks, particularly in terms of interest rates and currency interventions. The models and data suggest that the U.S. lowering its policy rate, either in general or in reference to a monetary policy rule, influences other central banks to lower their own policy rates and intervene in currency markets, even when controlling for worldwide macroeconomic trends. It thus appears that U.S. actions were a factor in the worldwide lowering of interest rates and the increase in currency reserves in the early 2000s that may have contributed to the subsequent global liquidity boom.
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Notes
The Taylor rule, first published by Taylor (1993) is the simplest and most ubiquitous rule in the monetary economics literature. It is therefore an appropriate benchmark to use in studying central bank behavior relative to well-established monetary policy rules.
Unless noted otherwise, the data used is from Datastream.
Their quantitative methods include tracking key macroeconomic variables over time, Granger causality testing U.S. monetary policy against monetary policy of other countries, and plotting U.S. monetary policy variables against observed economic imbalances.
This drop in policy rates may be a negative deviation with respect to a particular monetary policy rule, or any other drop in policy rate levels that appear inappropriate to investors.
Theoretically, the central bank could also institute capital controls. Because large-scale capital controls are rare among developed countries in the last few decades, this is not considered in detail.
The algorithm is a Gauss-Seidel iterative technique imbedded into the Fair-Taylor method as programmed in Eviews 7. These figures use it in conjunction with the Broyden solver, and use deterministic expectations.
One can create an asymmetric version of the model by excluding exchange rate terms from Equations [1] and [3] to simulate a large domestic economy and a small foreign economy.
The countries are (in descending order of data availability): Australia, Canada, South Korea, the United Kingdom, Norway, New Zealand, Denmark, Israel, Brazil, the Eurozone, China, and Indonesia.
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The author would like to thank Professors John Taylor, Manuel Amador, Geoffrey Rothwell, Pete Klenow, and Ronald McKinnon of the Stanford Economics Department, as well as Mitchel Scott, for helpful guidance and feedback.
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Gray, C. Responding to a Monetary Superpower: Investigating the Behavioral Spillovers of U.S. Monetary Policy. Atl Econ J 41, 173–184 (2013). https://doi.org/10.1007/s11293-012-9352-0
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DOI: https://doi.org/10.1007/s11293-012-9352-0