A monetary policy accordion: Why do central banks from different countries expand and contract together?

During recent decades, the monetary policies of central banks have shown significant co-movements mostly led by major economies such as the US. We find that this can be explained even when central banks adopt “inward looking” policy rules without aiming to stabilize exchange rates. We develop an open economy dynamic stochastic general equilibrium (DSGE) model with an agency problem in the banking sector. Our study suggests two channels through which the foreign and home policy rates co-move. Following the terms of trade channel, an exogenous rise in the foreign policy rate results in a capital outflow and a depreciation of the home currency. As import prices rise, home inflation increases and imports decrease. Then, via the Taylor rule, the home central bank raises its policy rate. The balance sheet channel coupled with a borrowing constraint amplifies the effects of the foreign policy rate shock. Due to the capital outflows that follow from the increase in the foreign rate, home banks experience a contraction of their balance sheets. The borrowing constraint then generates a feedback effect. This financial accelerator makes funding scarce, puts upward pressure on the user cost of capital, and feeds into even higher inflation. The policy co-movement becomes stronger when (a) global financial markets are more integrated, (b) the home country’s openness is higher, and (c) the home central bank is more aggressive in fighting inflation.