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 economy models that capture these spillover effects onto Advanced Economies (AE) and Emerging Market Economies (EME). Using counterfactual experiments, we identify the decline in US imports as the primary mechanism by which a US monetary contraction affects other economies. We also document that EMEs exhibit more pronounced contractions compared with AEs. Counterfactual experiments attribute this to a lower share of dollar borrowing in AEs. We find that financial frictions (including frictions needed to explain deviations from uncovered purchasing power parity) are essential to understanding the propagation of US monetary shocks. Finally, our findings suggest that FX interventions are relatively ineffective at insulating an economy against US monetary policy shocks, though they are very effective for dealing with ‘noise’ shocks in financial markets.