Does Globalization Weaken Monetary Policy?

I find it difficult to construct scenarios under which globalization would interfere in any substantial way with the ability of domestic monetary policy to maintain control over the dynamics of domestic inflation.

Today there is a growing unease, even among some proponents of globalization, that the increasingly free flow of goods and capital around the globe may be eroding the ability of central banks to accomplish one of their most vital tasks: controlling inflation within their national borders. But in Globalization and Monetary Control (NBER Working Paper No. 13329), NBER Research Associate Michael Woodford concludes that, although globalization certainly poses new challenges, central banks large and small still retain considerable power to keep inflation in check.

After constructing many hypothetical situations and subjecting each to a complex array of technical analyses, Woodford consistently finds that central banks can continue to pull a variety of policy levers that will prevent inflation from ravaging their economies. "I find it difficult to construct scenarios under which globalization would interfere in any substantial way with the ability of domestic monetary policy to maintain control over the dynamics of domestic inflation," he writes, noting that the banks' power remains substantial even when one considers "extreme theoretical possibilities" that assume much greater levels of integration than exist today.

Woodford also rejects the argument put forth by some of his colleagues that central banks remain relevant in the new order, but that their ability to tamp down inflation is increasingly restricted to situations in which they act in concert. He notes that this assumption, left unchallenged, could be used as a "strong argument" for developing formal agreements among central banks to coordinate policy, or to go so far as to pursue global monetary union. But he believes there is no need for such radical changes when there is no indication that central banks have been rendered impotent as individual economic actors, and a considerable amount of evidence to the contrary.

In each situation Woodford examines, standard macroeconomic calculations show that a central bank intervention should be able to control domestic inflationary pressures, despite increasingly large global flows of capital and goods. For example, Woodford notes that there is a common conception, or misconception, that in globalized financial markets, any inflation caused by excess "liquidity" -- basically a situation in which there is an overabundance of money in search of investments -- will be determined solely by global, not national, forces. Therefore, so the thinking goes, individual central banks will be powerless to do anything about it, particularly in the case of small countries that "supply a small portion of global liquidity."

But Woodford disagrees. He notes, for example, that while the inflationary pressure may come from across the border, the central bank -- regardless of a country's size -- can use its ability to adjust domestic interest rates within its border to counteract the effect. It need not retreat from its path toward economic integration.

Similarly, Woodford shows that domestic savings and investment rates -- and, most important, the monetary policies that influence them -- remain significant determinants of inflation and are not subordinate to global savings and investment rates. And, he refutes the notion that as international trade in goods and services increases, domestic economies inevitably will face inflation whenever world demand exceeds world production capacity. Woodford's analysis shows that domestic policies to combat domestic inflation "swamp the effects of world inflation."

"Even in the case of a very small open economy, monetary policy does not cease to be effective for domestic inflation control as a result of globalization," he said. Woodford acknowledges that global economic integration is not irrelevant to the conduct of domestic monetary policy. For example, he notes that in an open economy, policymakers must now decide whether they should take action to stabilize "an index of domestic prices only or an index of prices of all goods consumed in the domestic economy."

But while globalization certainly should prompt adjustments in policies and approaches, Woodford does not believe it should be cause for alarm. And, he sharply disagrees with economists who argue that globalization means the "old models" of monetary policy no longer apply. Moreover, he believes policymakers should not be allowed to evade responsibility for controlling domestic inflation by blaming "implacable global market forces" that are beyond their control.

"It is true that, in a globalized economy, foreign developments will be among the sources of economic disturbances to which it will be appropriate for a central bank to respond," Woodford states. "But there is little reason to fear that the capacity of national central banks to stabilize domestic inflation will be weakened by increasing openness of national economies. Thus it will continue to be appropriate to hold national central banks responsible for domestic inflation outcomes."

-- Matthew Davis