The International Monetary Transmission Mechanism
Time series analysis shows that a US monetary tightening leads to economic contractions in non-US countries. We develop small open economy (SOE) models that include standard frictions like balance sheet effects, UIP frictions, sticky-in-dollar export prices, etc. that capture these spillover effects quantitatively. We also include the VAR-estimated import decline that accompanies US monetary tightenings. Using counterfactual experiments, we identify the decline in US imports as the most important mechanism by which a US monetary contraction affects other economies. We also document that Emerging Market Economies (EME) exhibit more pronounced contractions compared with Advanced Economies (AE). Additional counterfactual experiments attribute the limited contraction in AEs primarily to relatively high home bias in AE production. Finally, our findings suggest that FX interventions are relatively ineffective in mitigating the effects of a US monetary contraction that is accompanied by reductions in US imports and inflation. FX interventions are relatively more effective in the face of pure "noise" shocks in financial markets and in the scenario in which a US monetary policy contraction is not associated with a decline in US imports and inflation.