The Federal Reserve in a Globalized World Economy

Abstract

This paper starts from the theoretical observation that simple rules-based monetary policy will result in good economic performance in a globalized world economy and the historical observation that this occurred during the Great Moderation period of the 1980s and 1990s. It tries to answer a question posed by Paul Volcker in 2014 about the global repercussions of monetary policies pursued by advanced economy central banks in recent years. I start by explaining the basic theoretical framework, its policy implications, and its historical relevance. I then review the empirical evidence on the size of the international spillovers caused by deviations from rules-based monetary policy, and explore the many ways in which these spillovers affect and interfere with policy decisions globally. Finally, I consider ways in which individual monetary authorities and the world monetary system as a whole could adhere better to rules-based policies in the future and whether this would be enough to achieve the goal of stability in the globalized world economy. Economic research as far back as the early 1980s showed that simple rules-based monetary policy would result in good economic performance in a globalized world economy. 2According to this research, if each central bank in the world followed a steady monetary policy rule that was optimal for its own country's price and output stability, it would also contribute to a framework of stability for the other countries. In fact, quantitative research showed that there would be little additional gain from the central banks' jointly optimizing their policies. This finding was, and still is, the implication of empirically estimated multi-country monetary models with highly integrated international capital markets, no-arbitrage conditions in the term-structure of interest rates, forward-looking expectations, and price and wage rigidities. Carlozzi and Taylor (1985), Taylor (1985, 1993), Clarida, Gali and Gertler (2002, Obstfeld and Rogoff (2002 . 5 The Bank of Japan also announced an inflation target to 2 percent, which has an element of international cooperation because that is close to the numerical target of the Fed and the ECB. 4monetary system as a whole could adhere better to rules-based policies in the future and whether this would be enough to achieve the goal of stability in the globalized world economy. Policy Tradeoffs in a Globalized World EconomyThe idea that monetary policy rules deliver good economic performance in a globalized world economy comes out of a multi-country monetary modelling framework that I have been using in research and graduate teaching for many years (Carlozzi and Taylor (1985), Taylor (1993, 2013a)). 6 It assumes perfect capital mobility (as in the original Dornbush-MundellFleming model), which is of course quite appropriate for a "globalized world economy." It also assumes staggered wage and price setting as in the Taylor (1980) model, so that inflation today depends in part on inflation in the future. Domestic prices in each country are a...