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Global economic integration and monetary policy.

A number of key forces have forged significant changes in the environment facing monetary policymakers. This changed environment must be taken into account in selecting appropriate policy tools as well as in actually formulating and implementing monetary policy. After reviewing these changes as well as the forces bringing them about, this article summarizes three important implications for contemporary monetary policy. In particular, the appropriate data to use in conducting monetary policy, the importance of a nominal anchor under a flexible exchange regime, and the significance of coordinating monetary policy among several countries are discussed.

ANY CONTEMPORARY DISCUSSION of monetary policy must recognize the increasingly important integration of the global economy. And competent monetary policymakers must understand the policy implications of this increased integration as well as how to achieve monetary stability in a well-integrated world economy.

This paper discusses the formulation and implementation of monetary policy by central banks in a deregulated, globally integrated financial system. In short, it discusses monetary policymaking in circumstances that approximate those existing today.

Before discussing the details of such policy-making, however, it is useful to describe briefly the nature of the current monetary regime in which we operate as well as the forces shaping change in modern economic and financial systems.


The world's major trading areas generally operate under a fiat money/flexible exchange rate regime. Admittedly, currency arrangements appear to be evolving into a system of multipolar currency blocs. Smaller countries tend to peg their currencies to those of their larger trading partners, fostering the formation of large currency areas. The currencies of the larger countries, however, float against one another. Thus, the term flexible" is used advisedly; perhaps "managed" or "semi-" float would be more appropriate.

A good deal of (largely sterilized) intervention has occurred in recent years. Nevertheless, exchange rates between major trading regions move frequently and often by substantial magnitudes. These movements have led many observers to argue that foreign exchange rates are both excessively volatile and frequently "overshoot" their equilibrium values.

Exchange rate movements, however, play an increasing role in the transmission of changes in monetary policy and can play a significant role in fostering balance-of-payments adjustment. In spite of these movements in exchange rates, reserve holdings among key countries have increased; this conflicts with the common belief that reserve holdings would decline with the abandonment of the Bretton Woods system. Furthermore, the dollar continues to serve as a key reserve currency under current international monetary arrangements.


A number of forces have worked to shape our current environment. Revolutions in telecommunications and information processing have dramatically lowered the costs of acquiring, disseminating, and processing information and undoubtedly have quickened the pace of the integration process. These changes fostered a host of financial innovations that enabled price, geographic, and product regulations of various financial services to be readily circumvented. These circumventions and innovations, in turn, promoted some long-sought deregulation of financial services as well as a substantial reduction of international capital controls. All of these changes promoted the efficiency of both financial markets and the global macroeconomy.

These many developments have dramatically changed the world; no part of our world - not even the remaining centrally planned economies - has escaped the effects of these changes. Indeed, the above-cited improvements in the workings of market-based systems underscored the growing problems of centrally planned economies. In particular, the rapid growth of both information and knowledge has contributed to an increasingly complex world; yet this information and knowledge is, by its very nature, decentralized and dispersed. Because of this - and as demonstrated by the socialist-calculation debate of the 1930s - market-based systems employing market-price signals are necessarily more efficient at processing and transmitting information about relative supply and demand conditions and providing incentives to produce and distribute desired goods and services. Thus, it has become increasingly obvious that market-based economies are significantly more efficient at both using dispersed information and knowledge and allocating resources than those command economies under centralized control. Because market economies operate more efficiently, they promote faster growth and higher living standards than centrally planned economies.


How do these many changes manifest themselves to the practical policymaker? What types of properties characterize our changed financial environment?

Today, our financial environment is characterized by increasingly large and rapid flows of money and capital. Not only has the size of capital flows increased dramatically in recent years, but capital transfers occur more quickly; many financial adjustments or provisional payments settlements can now occur virtually instantaneously. Furthermore, these movements are continuous: foreign exchange and even some futures markets operate twenty-four hours a day around the globe. In the industrialized world, narrowly defined currency substitution has not proved empirically important, but this situation could change. Nevertheless, it has already been recognized that these substantial capital flows are now so potent that they likely drive trade flows rather than vice versa.

Portfolio adjustments within national borders and between various domestic financial markets have also become large and rapid. Large sums of money and financial capital can easily and quickly be transferred from one financial market to another, or from one financial instrument to another by both individuals and corporations. The advent of money-market mutual funds, stock-index futures, and program trading serve as relevant examples.

That financial markets are now more interdependent and less separate and segmented is another manifestation of an increasingly integrated financial environment. National economies are significantly more sensitive to international factors than they were in the past. All economies are increasingly open; only the world economy is truly closed. In this environment, prices of financial assets, traded goods, and interest rates have become increasingly interrelated and can even move in unison, depending on exchange rate relationships. This increased financial integration is exemplified by the October 19, 1987, worldwide stock market crash.

An important implication of this growing interdependence is that the U.S. economy increasingly is a portion, albeit a major portion, of the global economy rather than the overwhelmingly dominant force it was immediately after World War 11. Consequently, the actions or policies of other important countries can now have important spillover effects on U.S. markets via movements in exchange rates, interest rates, or other financial asset prices. Research has shown that the variability of exchange rates, commodity prices, bond prices, and equity prices has been significantly greater during the past several years relative to the earlier postwar period. Part of this increased volatility is the result of greater international financial integration combined with perceived inconsistencies of domestic monetary and fiscal policies among industrial countries as well as more efficient information processing (i.e., the influence of "news" on financial markets).


There are several major monetary policy implications arising from this new environment. Three of these implications pertain to (1) the appropriate data for use in conducting monetary policy, (2) the appropriate nominal anchor for the system, and (3) the coordination of monetary policy.


One important implication of our new environment relates to the appropriate data to use in the formulation of monetary policy. The information requirements of monetary authorities operating in integrated environments are increasingly complex. Central banks require relevant, reliable information that is quickly and continuously available if they are properly to implement policies in a rapidly changing environment. Forward-looking information is particularly helpful, given that monetary policy necessarily relates to the future.

Yet it is evident that we live in an increasingly complex world of vast information needs where knowledge is decentralized and highly disaggregated. Thus, for this information to be useful to policymakers, mechanisms are necessary to summarize or aggregate it.

Problems with Quantity Data

Accurately compiling and measuring financial quantity variables in a timely fashion have proven difficult primarily because of the large and rapid flows of financial capital fostered by financial integration and deregulation. In our rapidly changing world, the time-consuming and cumbersome process of sampling, collecting, and compiling large amounts of quantity data is not likely to be the most effective way of summarizing and aggregating information or of obtaining timely and accurate data upon which to base policy decisions.

Measures of the quantity of money and financial capital are, after all, necessarily based on samples. Accordingly, such quantity data are subject to revisions and rebenchmarks that can often be substantial. Sampling takes time, so that there is an inherent lag in the reporting of such data. Because financial flows move so rapidly today, quantity measures are often outdated and sometimes even obsolete by the time they are compiled and published. Measures of international financial capital movements, for example, are both notoriously inaccurate and sometimes published several months after they were originally sampled.

Other measures of financial quantities are also more difficult to measure. The proliferation of transactions instruments associated with deregulation, together with the ease of portfolio adjustments, have rendered the measurement of domestic financial variables difficult as well. It is well known, for example, that the accurate measurement of narrowly defined transactions balances is increasingly difficult. In part because of these measurement difficulties, transactions balances (such as MI) have become much less useful as guides to monetary policy than was earlier the case.

Other problems with quantity data exist. For quantity data to be useful, they must be seasonally adjusted. If redefinitions of variables occur because of deregulation, technological or institutional developments, then the altered measurements and changed behavior of particular variables can be substantial.

Thus, the use of sample-based quantity data can result in significant measurement, timing, and sometimes definitional problems, particularly in a financial system that is rapidly changing and increasingly integrated.

Advantages of Price Data

Price data from centralized auction markets (such as bond, foreign exchange, and commodity markets), however, have a number of advantages for use as policy guides, especially in our modern, fast-paced integrated world. The reason is straightforward: financial market prices are summaries of or aggregators of information embodying the knowledge and expectations of large numbers of buyers and sellers who have incentives to make informed decisions in an uncertain world. Active competitive markets are a mechanism efficiently absorbing and processing dispersed information. And a key purpose of prices - especially prices of this type - is to transmit and to convey information. As a consequence of this property, financial market prices yield useful information. Furthermore, they are timely and available by the minute. Financial market prices, unlike quantity data, are accurate, easy to understand, less subject to sampling error, and are not subject to revisions, rebenchmarks, seasonal adjustments or "shift-adjustments." Because market prices embody expectations of the future, they are inherently forward looking, offering a distinct advantage over any form of quantity data. This characteristic is particularly important for monetary policymakers who necessarily must be forward-looking decisionmakers.

Using Price Data for Monetary Policy

If price stability is a goal of monetary policy, certain financial market prices may be particularly useful policy indicators for perceptive monetary authorities Price stability, after all, is another way of saying that the central bank's objective is to stabilize the exchange rate between goods and money. But directly targeting general price measures may not be feasible, because there are well-known long and variable lags between policy action and movements in general prices. Because of this, intermediate policy indicators that reliably reflect policy change and lead changes in inflation are essential.

Three such intermediate market price indicators have been identified. Movements in broad indices of commodity prices, for example, can serve as useful proxies for changes in the exchange rate between money and commodities. While individual commodity prices may be influenced by commodity-specific factors, using broad-based commodity price indices minimizes the probability of such influences. Movements in such broad-based indices, therefore, can usefully serve as proxies for changes in the price of money.

Exchange rate movements, on the other hand, can be interpreted as useful indicators of movements in the price of money in terms of foreign monies. All else equal, easy monetary policy in one country will bring about a fall in the value of that money relative to other monies. Accordingly, exchange rates can be useful indicators in a price stabilizing monetary regime, because exchange rate movements can signal changes in the value or price of money from another dimension: the international perspective.

The price of bonds is also a useful indicator in signaling changes in the value of money. Because a bond is a promise to pay a given quantity of money in the future, changes in the value of outstanding bonds signal changes in the value of future money, i.e., changes in bond prices signal changes in the price of money from an intertemporal dimension. In short, changes in the price of money in terms of bonds provide information as to how well money is serving as a standard of deferred payments or how well money is maintaining its value over time.

All of these market prices, therefore, tell us something about the value of money from a differing perspective of the price system. The strategy of using all of these market prices in conjunction with one another to decipher changes in the price of money is a strategy of using the price system to gauge changes in the value of money. As such, the strategy reflects the collective views of millions of decentralized market participants, each acting on bits of information available to the individual market agent - which, because information is dispersed and decentralized, may be as good as any information available to centralized decisionmakers. By judiciously using and assessing these prices in conjunction with one another (by carefully extracting relevant information from the price system) policy-makers can best take advantage of dispersed, decentralized information to gauge changes in the value of money and therefore more successfully pursue a price stabilization strategy.

Furthermore, because all of these financial market prices are forward looking, they contain information about expectations of inflation. If participants consider monetary policy to be too easy and expect inflation to increase, for example, commodity prices and bond rates will be bid up to command an inflation premium and the exchange rate will depreciate to account for the expected reduction in purchasing power of the currency. By using market price information, monetary policymakers employ a policy apparatus including data) better suited to ever-and-rapidly-changing conditions than strategies using various forms of quantity data.

Using Price Data for Lender-of-Last-Resort Responsibilities

Market price indicators are not only useful in the everyday conduct of monetary policy, but they are also quite useful for monetary authorities in financial crises when lender-of-last-resort responsibilities become relevant. It is in these circumstances that many forms of monetary or reserve aggregates often prove particularly misleading for two important reasons. First, in such circumstances, demands for liquidity can change and dramatically. Demands for currency, excess reserves, and other quality assets, for example, often increase sharply. The quantity of reserves or narrow transactions aggregates can often prove quite misleading guides to policy in this case. Second, the demand for these instruments can often change on an hour-to-hour basis. Thus, by the time these quantity data are compiled or published, they are obsolete.

In contrast, market price data are readily available, literally by the minute. Lender-of-last-resort policy decisions during a financial crisis necessarily must be made very quickly. The data essential to support such decisions, therefore, must be readily available and timely. Quantity data (such as the monetary or reserve aggregates) are ill-suited for these situations, whereas market price data are eminently appropriate.

Sharp decreases in Treasury bill and bond yields, for example, could signal a flight to quality as well as work to flatten or invert the fed funds/Treasury bond yield spread. And dollar depreciation could occur depending on the national or international nature of the financial crisis. In short, key market prices may immediately signal the need for an increased supply of central bank liquidity; these prices can provide correct, timely signals to the central bank in such circumstances. Other market price data such as quality spreads," bank stocks, and even gold prices may also yield useful information on a timely basis in such circumstances. In sum, market price data are quite useful to monetary authorities in the current environment both for everyday monetary policy, as well as for emergency (lender-of-last-resort) responsibilities.


Another important implication of the current environment facing monetary policy relates to the appropriate nominal anchor for the monetary regime. Under any fiat money/flexible exchange rate regime, of course, a nominal anchor is essential. Accordingly, the market price guides just discussed should be credibly linked to a price stabilization objective. For example, any sustained rise in both nominal bond yields and commodity prices combined with a general weakening in the exchange rate would likely signal rising inflation expectations or expectations of a fall in the value of money with regard to future money, commodities, and foreign monies, respectively. With price stability a credible policy goal, these signals would trigger a policy tightening in order to avoid future price increases. Analogous to a Wicksellian-like approach to policy, the central bank would increase its bank rate until it observed signals from these markets indicating that future inflation was no longer anticipated. Such market-price-induced policy adjustments should be made continually and assessed in conjunction with general price movements as well as with reliable measures of price expectations in order to provide a reliable anchor to the system. A price stability objective should be both announced and credible. Inflation is positively correlated with increased volatility in both financial and other markets; thus, policies designed to produce a stable price environment will likely help to ensure that such volatility is lower than would otherwise be the case. In short, the provision of price stability ensures that movements in relative prices better reflect changes in relative scarcities and hence enables the price system to better carry out its all-important information disseminating function. Furthermore, it is important that price stability become the common monetary policy objective of the major industrialized countries; coordination efforts toward the goal of price stability can contribute significantly to reduced volatility of exchange rates and other relative financial market prices.


The increasingly integrated global financial system also implies that the goal of price stabilization cannot be effectively achieved in isolation without taking into account exchange rates and the policies of other countries. Whether we like it or not, cooperation among the major economies becomes more and more important in order to avoid excessive or undue financial volatility and potentially disruptive shifts in international capital flows.

As a consequence, central bank policies designed to coordinate price stabilization objectives across countries merit both our attention and support. While coordination is increasingly important, flexibility is still appropriate. In particular, countries should have the flexibility to insulate their economies from irresponsible policies pursued elsewhere as well as from external shocks of various forms. If some flexibility is not maintained, such shocks or policy mistakes could be transmitted across the bond and stock markets of all major countries and could therefore adversely affect the performance of all macroeconomics. While flexibility is important, movements in exchange rates that reflect changes in monetary policy cannot be ignored by monetary authorities. And coordinating monetary policies so as to ensure that price stability anchors the system will contribute to reducing excessive exchange rate volatility.

Because our current financial environment implies (1) that price data have important advantages vis-a-vis quantity data, (2) that a price anchor is essential, and (3) that monetary policy should be coordinated, it follows that market price data might be particularly useful in coordinating price stabilizing monetary policies. Such market-price-assisted policy coordination can often profitably be undertaken by using commodity prices and exchange rates in combination with one another.

When central banks monitor movements in commodity prices in conjunction with exchange rates, for example, they can often determine whether a given inflation is local or global in character. Such a determination may provide guidance as to which country should pursue a relatively tighter policy and which should pursue a relatively easier policy.

Should domestic currency be appreciating against a basket of other currencies while broad indices of commodity prices are increasing, for example, then it may be the case that domestic monetary policy should tighten, but not tighten as much as should foreign monetary policy. These market price indicators, therefore, may help to signal the type of policies that should be undertaken in various countries; they may be useful in the coordination of monetary policy.

Coordination of monetary policy that goes so far to stabilize exchange rates, however, reduces that information previously provided by exchange rate movements. In this situation, the information provided by movements in other market prices, such as commodity price movements, becomes increasingly important. In particular, commodity price movements can provide vital information about the aggregate monetary policy of those countries coordinating policy; commodity prices can provide valuable information as to global inflation or deflation and thereby provide information that can help to anchor the system. In this situation, it may be particularly important for a key currency country to monitor commodity prices in assessing price developments. (In this context, it is noteworthy that in 1987 Treasury Secretary Baker proposed that commodity prices be included among the indicators monitored by the G-7 countries.)


Monetary policymakers operate under a fiat money/flexible exchange rate regime. The current environment can be characterized as an integrated, deregulated global financial system where information is dispersed and decentralized.

This environment produces large, rapid, and continuous adjustments of money and financial capital. Increased economic integration implies that domestic financial markets have become more sensitive to international forces.

These developments have several important policy implications. The many advantages of market price data suggest that market prices are more appropriate for use as monetary policy guides than quantity variables in an integrated financial environment. Such market price guides are not only useful in conducting normal monetary policy operations, but can also be useful in financial crises when lender-of-last-resort responsibilities become relevant. Price stability is essential to anchor the system under a fiat money, flexible exchange rate regime. Yet, because the world is becoming increasingly integrated, coordinated monetary policy action is desirable. Market prices used in conjunction with one another can also be useful in such coordination efforts.
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Title Annotation:A Review of Federal Reserve Policy
Author:Johnson, Manuel H.; Keleher, Robert E.
Publication:Business Economics
Date:Jul 1, 1991
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