Globalization is a process that has been associated with massive deregulation and an increase in financial innovation in countries around the world. These two factors have increased the liquidity of assets in the existing markets and created new trade opportunities. This has made it easier for investors to trade financial risks, and as a result, they are able to hedge against those risks more effectively.
In this sense, globalization can be seen as moving us closer to a perfect financial market system. This can be discussed further within the realm of “New Monetary Economics.”
Before we dive deep into exploring globalization impacts monetary policy.
let us first get a historical perspective.
Historic perspective
The discovery of the Americas in centuries past led to a sudden influx of gold and silver in the new world, which caused inflation rates to rise across all of Europe. This period in economic history is known as the price revolution.
There is always a debate about what caused inflation during the price revolution. Some say that it was because of an increase in liquidity due to a surplus of money in the system. In contrast, others argue that it was due to economic slack decreasing as a result of urbanization and rising income levels. However, whatever the cause may have been, one thing is for sure: The discovery of the Americas significantly impacted global inflation rates.
Today, there is still a lot of debate about how globalization affects inflation rates. Some people argue that the flattening of the Phillips curve is due to globalization, while others say that the overall increase in global economic slack is responsible. Though its cause is unknown, it is clear that globalization has significantly impacted global inflation rates.
Now let us explore different views
New Monetary Economics
New Monetary Economics has significantly influenced how we think about globalization and its impact on monetary policy. It tries to understand how these global interactions affect the transmission mechanism through which global events influence individual economies. Thus, it focuses on the transmission mechanism and how it impacts domestic economic activity.
One of New Monetary Economics’ main contributions is that, although globalization has increased international trade and capital flows, there has been very little net change in cross-border bank lending since the 1980s. It suggests that only a tiny portion of increased financial integration between countries can be attributed to banks acting as agents for international investors when investing abroad or borrowing from foreign lenders when making loans at home.
A significant chunk of global growth in aggregate demand and credit was instead driven by new instruments, such as asset-backed securities created after deregulation, allowing financial institutions more flexibility in their investments.
New Monetary Economics also helped us understand what kinds of changes we should expect from these new instruments and how they affect the transmission mechanism.
The Conventional view on Globalization
Under the influence of a more conventional view of monetary economics, it has been debated that globalization will ultimately reduce the effectiveness of monetary policy.
This is because financial market innovations such as derivatives allow banks to react faster to monetary policy shocks while allowing non-banks and large investors to shield themselves against such shocks to a certain extent. Thus, overall the transmission mechanism of monetary impulses to the economy becomes weaker.
This argument can be further substantiated by the traditional IS-LM paradigm and can also be analyzed with the credit-market view of monetary policy transmission. Therefore, globalization in the form of financial innovation and financial market expansion creates more stability in the financial system and decreases the overall impact of monetary policy shocks.
Academic findings
Rogoff (2003) was amongst the first academicians to study the impact of globalization on inflation. He found that, due to globalization, inflation rates around the world had become much more stable and lower, usually staying within a range of 1-2%. He argued that this was due to the increased flexibility of prices for commodities and services as a result of globalization. This has led central banks to have less incentive to inflate their economies, making globalization a force for lowering global inflation rates.
Borio and Filardo looked at data from 16 advanced economies and the Euro area to see how inflation rates respond to economic slack (a measure of how much production is below potential). They found that foreign economic slack has significant explanatory efficacy in describing domestic inflation rates.
Badinger looked at data from 91 countries to see if globalization affects the output-inflation trade-off. He also supported the claim that higher trade and financial openness, which is referred to as globalization, reduces the central banks’ inflation bias while simultaneously leading to a more significant output-inflation trade-off.
Conclude Debate
Let us summarize two narratives that come out of this long ongoing debate about the impact of globalization on monetary policy to control inflation rates.
It is clear that globalization has significantly affected global inflation rates. However, what is not so clear is the cause of this phenomenon. Some argue that globalization has led to a more significant output-inflation trade-off for central banks.
Others say financial innovation and market expansion create more stability in the financial system and decrease the overall impact of monetary policy shocks. However, whatever the cause may be, it is evident that globalization has profoundly affected how economies function worldwide.
First narrative: Globalization has had a negligible effect on inflation rates because most countries have gained greater economic stability due to financial innovation and market expansion.
Evidence for the first narrative:
Several pieces of evidence support the claim that globalization has had a stabilizing effect on inflation rates. First, as economies have become more integrated, central banks have been able to coordinate their policies better. This has led to fewer monetary policy errors and reduced the overall volatility of inflation rates.
Second, increased competition in global markets has put downward pressure on prices and prevented inflation from spiraling out of control. Finally, greater financial integration has allowed investors to quickly shift capital to areas where it can be used most efficiently, mitigating the effects of any shock.
Second narrative: Globalization has significantly affected inflation rates because it has led to a more significant output-inflation trade-off for monetary policy authorities.
Evidence for the second narrative:
The most crucial evidence for this argument is that developing countries have generally experienced higher inflation rates than developed countries over the past few decades. These countries are more exposed to external shocks and typically have less effective monetary policies.
As a result, when central banks in these countries tighten monetary policy in an attempt to control inflation, it often leads to slower economic growth and higher unemployment levels.
Reference:
Obstfeld, M. (2021). Trilemmas and tradeoffs: living with financial globalization. In The Asian Monetary Policy Forum: Insights for Central Banking (pp. 16-84).
Carney, M. (2019, August). The growing challenges for monetary policy in the current international monetary and financial system. In Remarks at the Jackson Hole Symposium (Vol. 23).
Badinger, H. (2009). Globalization, the output–inflation trade-off and inflation. European Economic Review, 53(8), 888-907. doi: 10.1016/j.euroecorev.2009.03.005
Borio, C., & Filardo, A. (2007). Globalization and Inflation: New Cross-Country Evidence on the Global Determinants of Domestic Inflation. SSRN Electronic Journal. doi: 10.2139/ssrn.1013577
