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Monetary Policy Spillovers, Capital Controls and Exchange Rate Flexibility, and the Financial Channel of Exchange Rates

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  • Georgios Georgiadis
  • Feng Zhu

Abstract

We assess the empirical validity of the trilemma (or impossible trinity) in the 2000s for a large sample of advanced and emerging market economies. To do so, we estimate Taylor-rule type monetary policy reaction functions, relating the local policy rate to real-time forecasts of domestic fundamentals, global variables, as well as the base-country policy rate. In the regressions, we explore variations in the sensitivity of local to base-country policy rates across different degrees of exchange rate flexibility and capital controls. We find that the data are in general consistent with the predictions from the trilemma: Both exchange rate flexibility and capital controls reduce the sensitivity of local to base-country policy rates. However, we also find evidence that is consistent with the notion that the financial channel of exchange rates highlighted in recent work reduces the extent to which local policymakers decide to exploit the monetary autonomy in principle granted by flexible exchange rates in specific circumstances: The sensitivity of local to base-country policy rates for an economy with a flexible exchange rate is stronger when it exhibits negative foreign-currency exposures which stem from portfolio debt and bank liabilities on its external balance sheet and when base-country monetary policy is tightened. The intuition underlying this finding is that it may be optimal for local monetary policy to mimic the tightening of base-country monetary policy and thereby mute exchange rate variation because a depreciation of the local currency would raise the cost of servicing and rolling over foreign-currency debt and bank loans, possibly up to a point at which financial stability is put at risk.

Suggested Citation

  • Georgios Georgiadis & Feng Zhu, 2019. "Monetary Policy Spillovers, Capital Controls and Exchange Rate Flexibility, and the Financial Channel of Exchange Rates," Globalization Institute Working Papers 363, Federal Reserve Bank of Dallas.
  • Handle: RePEc:fip:feddgw:363
    DOI: 10.24149/gwp363
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    Cited by:

    1. Christian Friedrich & Pierre Guérin & Danilo Leiva-Leon, 2020. "Monetary Policy Independence and the Strength of the Global Financial Cycle," Staff Working Papers 20-25, Bank of Canada.
    2. Ahmed, Rashad, 2021. "Monetary policy spillovers under intermediate exchange rate regimes," Journal of International Money and Finance, Elsevier, vol. 112(C).
    3. Çekin, Semih Emre & Hkiri, Besma & Tiwari, Aviral Kumar & Gupta, Rangan, 2020. "The relationship between monetary policy and uncertainty in advanced economies: Evidence from time- and frequency-domains," The Quarterly Review of Economics and Finance, Elsevier, vol. 78(C), pages 70-87.
    4. Ca' Zorzi, Michele & Dedola, Luca & Georgiadis, Georgios & Jarociński, Marek & Stracca, Livio & Strasser, Georg, 2020. "Monetary policy and its transmission in a globalised world," Working Paper Series 2407, European Central Bank.
    5. Isabella Moder, 2023. "The transmission of euro area monetary policy to financially euroized countries," Economics and Politics, Wiley Blackwell, vol. 35(3), pages 718-751, November.
    6. Georgiadis, Georgios & Jančoková, Martina, 2020. "Financial globalisation, monetary policy spillovers and macro-modelling: Tales from 1001 shocks," Journal of Economic Dynamics and Control, Elsevier, vol. 121(C).
    7. You, Yu & Liu, Fangzheng & Yang, Da, 2023. "Macroprudential policy, capital flow management and monetary policy independence," The Quarterly Review of Economics and Finance, Elsevier, vol. 88(C), pages 116-132.
    8. Pierre-Richard Agénor & Timothy P. Jackson & Luiz Pereira da Silva, 2020. "Foreign Exchange Intervention and Financial Stability," Working Papers 202027, University of Liverpool, Department of Economics.
    9. Ahmed, Rashad, 2020. "Monetary Policy Spillovers under Intermediate Exchange Rate Regimes," MPRA Paper 98852, University Library of Munich, Germany.
    10. Victor Shevchuk & Roman Kopych, 2021. "Exchange Rate Volatility, Currency Misalignment, and Risk of Recession in the Central and Eastern European Countries," Risks, MDPI, vol. 9(5), pages 1-19, May.
    11. Loipersberger, Florian & Matschke, Johannes, 2022. "Financial cycles and domestic policy choices," European Economic Review, Elsevier, vol. 143(C).

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    More about this item

    Keywords

    Trilemma; financial globalization; monetary policy autonomy; spillovers;
    All these keywords.

    JEL classification:

    • C50 - Mathematical and Quantitative Methods - - Econometric Modeling - - - General
    • E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy
    • F42 - International Economics - - Macroeconomic Aspects of International Trade and Finance - - - International Policy Coordination and Transmission

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