Conducting monetary policy in an interconnected world

Extension n ° 247

Conducting monetary policy in an interconnected world

Posted on 12/20/2021

Since the last review of the ECB’s strategy in 2003, interdependencies between countries have increased, making the economic and financial conditions of the euro area more subject to foreign influence. However, the analyzes underlying the new ECB strategy review conclude that globalization does not prevent the ECB from achieving price stability, but calls for the adaptation of instruments and analytical toolkits.

Figure 1: Trade openness 1995-2020, euro zone and worldSource: Authors’ calculations based on World Development Indicators and European Central Bank data. Trade openness is defined as the sum of imports and exports divided by GDP.

Trade and financial integration is much deeper than in 2003

the Review of the ECB’s strategy, launched in January 2020, ended in July 2021 with the announcement of a new monetary policy strategy and the publication of the detailed analyzes behind. The previous ECB strategic review dated back to 2003, ie before the era of “hyper-globalization”. The main structural changes in the global trading system included an impressive increase in the weight of emerging economies, especially China and other Asian countries, and the massive development of global production networks through global value chains (Berthou, Carluccio and Gaulier, 2020). Gross cross-border financial flows increased from 2.5% of global GDP in the early 1990s to around 20% in 2007, a notable fact being the expansion of the World Bank (Figure 2, where “other investments” mainly include bank flows which recorded strong growth before 2008, before stabilizing).

Figure 2: Cross-border financial flows, 2000-2020Source: Authors’ calculations based on data from IMF Balance of Payments Statistics, IMF International Financial Statistics and United States Bureau of Economic Analysis.

Overall, despite the leveling off after the Great Financial Crisis, which affected the euro zone less than the rest of the world, most economies are now much more integrated than they were in 2003 and there are signs of an outright reversal of globalization are limited. These changes have strongly affected the landscape in which monetary policy operates, as noted by a recent report conducted as part of the review of the monetary policy strategy of the BCE.

Increased synchronization of economic and financial cycles between countries

Economic and financial variables between countries move more closely in a world characterized by stronger trade and financial ties. Such synchronization is noticeable for real variables such as business cycles and for financial variables. Fluctuations in capital flows and the prices of risky assets respond to global factors common to all countries. It is important to note that inflation in the euro area has become increasingly synchronized with that of other advanced economies, in particular due to the co-evolution of the more volatile parts of the CPI. Moreover, although globalization has affected the setting of prices and wages, the analysis concluded that it had a second-order effect on core inflation and on the flattening of the Phillips curve, relative to to factors such as the de-anchoring of inflation expectations. One of the reasons behind this – perhaps counterintuitive – result is that, while trade openness can intensify competition and therefore put downward pressure on inflation, it has also been associated with the emergence of superstar companies operating in oligopolistic contexts which tend to absorb cost fluctuations within their margins. Furthermore, although the share of goods from low-wage countries in euro area consumer spending has doubled since the early 2000s, the overall contribution to inflation of the consumer price index ( CPI) has been rather modest because inflation in these countries has increased at a rate similar to that of the euro zone (even slightly faster) – see Balatti et al, (2021) for a detailed discussion of the impact of globalization on inflation).

Globalization affects the environment in which monetary policy operates

Strategy review globalization study concluded that trade integration helps boost productivity growth by improving the allocation of resources to the most productive countries, sectors and firms, and by providing incentives for technological innovation. It also shows that financial integration explains to some extent the fall in the natural interest rate (the rate at which inflation is constant over the long term, denoted r *) by increasing the supply of global savings and stimulating global demand for safe products. assets. r * has declined steadily over the past decades (Figure 3, Federal Reserve Bank of New York) (Marx, Mojon and Velde, 2017; Brand, Bielecki and Penalver, 2018). The report also documents that globalization has been associated with greater inequality of wealth and income within countries.

It modifies the transmission channels of monetary policy but not their relevance

The natural question is whether, and how, the transmission mechanisms of monetary policy are affected by international interconnection. Through its impact on r * and on inequalities, globalization limits what is called the “interest channel” by reducing (to a certain extent) the political space and by modifying the overall propensity to consume, households to consume. low income tending to save less. Globalization also affects the “wealth channel”, ie the impact of interest rates on demand via portfolio holdings, with wealth being more concentrated and held abroad. More importantly, globalization is associated with more complex exchange rate dynamics. Financial globalization implies a greater sensitivity of exchange rates to monetary policy shocks via a rapid rebalancing of the portfolio and the valuation effects of foreign currency exposures, and a more active role of global banks in the transmission of shocks to the beyond borders (“global financial cycle” hypothesis). Trade integration, on the other hand, allows consumers to switch spending between domestic and foreign goods as a result of a change in the exchange rate induced by monetary policy, thereby strengthening the exchange rate channel. At the same time, however, globalization has been associated with a greater role for dominant currencies in the invoicing of international trade, particularly the US dollar and the euro, thus mitigating the real effects of devaluations.


The world is much more open and interconnected today than at the start of the euro. A more open economy is more likely to be affected by shocks (positive and negative) from elsewhere in the world. While one might think that such an interconnection could hamper the sovereignty of monetary policy, research dismisses such claims, providing the good news that medium-term inflation in the euro area remains under the control of the ECB. just as much as at the start of the 2000s. Indeed, the ECB’s monetary policy was very active in developing new instruments to provide monetary stimulation during the crisis, in particular during the very acute phase at the start of 2020, for example with the introduction of swap lines to cope with the shortage of US dollars (Schmidt, 2020) and euros (Albrizio et al, 2021). Globalization only requires extra work from Eurosystem staff to grasp the complexities of the integrated world and feed them into their analytical toolkits.

Updated on 12/20/2021 16:57


Bank of France published this content on 20 December 2021 and is solely responsible for the information it contains. Distributed by Public, unedited and unmodified, on December 20, 2021 04:49:07 PM UTC.

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