A Welfare‐Based Analysis of International Monetary Policy Spillovers at the Zero Lower Bound

• Published date: 01 August 2020
• Author: ALEX HABERIS,ANNA LIPIŃSKA
• Date: 01 August 2020
• DOI: http://doi.org/10.1111/jmcb.12655

DOI: 10.1111/jmcb.12655

ALEX HABERIS

ANNA LIPI ´

NSKA

A Welfare-Based Analysis of International

Monetary Policy Spillovers at the Zero Lower

Bound

We study the welfare effects of international monetary policy spillovers at

the zero lower bound, focusing on the effects of forward guidance in a large

economy (“foreign”) on its smaller trading partner (“home”) in scenarios

motivated by the global financial crisis. Wefind that foreign forward guid-

ance has an overall prosper-thy-neighbor effect on the home economy as

long as it increases foreign welfare. This finding holds under alternative

assumptions about exchange rate pass-through or the degree of international

financial integration. However, foreign forward guidance may worsen the

trade-off between the stabilization objectives of home monetary policy.

JEL codes: E58, F41, F42

Keywords: small open economy, welfare, spillovers, monetary policy.

MAJOR ECONOMIES ACROSS THE WORLD experienced a deep re-

cession and slow recovery as a result of the 2007–08 global financial crisis (GFC).

Central banks responded by taking unprecedented actions, which involved cutting

policy rates to the zero lower bound (ZLB), followed by the use of unconventional

policy tools. One of the most implemented unconventional policies was forward

guidance: central banks communicating how they intend to adjust their policy in-

strument(s) in the future.1The size and simultaneity of these policy actions raised

The views expressed in this paper are solely the responsibility of the authors and should not be

interpreted as reflecting the views of the Bank of England, or its committees, or the Board of Governors

of the Federal Reserve System or of any other person associated with the Bank of England or the Federal

Reserve System.

ALEX HABERIS is at the Bank of England and Centre for Macroeconomics (Email:

alex.haberis@bankofengland.co.uk). ANNA LIPI´

NSKA is at the Federal Reserve Board (Email:

anna.lipinska@frb.gov).

Received March 20, 2015; and accepted in revised form March 4, 2019.

1. A number of central banks around the world have implemented policies along these lines, most

notably the U.S. Federal Reserve in 2011 and 2012 and the European Central Bank in 2013.

Journal of Money, Credit and Banking, Vol. 52, No. 5 (August 2020)

C

2019 Bank of England. Journal of Money, Credit and Banking. C

2019 The Ohio State

University.

This article has been contributed to by US Government employees and their work is in the

public domain in the USA.

1108 :MONEY,CREDIT AND BANKING

concerns among policymakers about the possible adverse international spillovers

of monetary policy. Indeed, in their Spring 2013 Communiqu´

e, the G20 Finance

Ministers and Central Bank Governors stated that they were “mindful of unintended

negative side effects stemming from extended periods of monetary easing” and that

they intended to “refrain from competitive devaluations” (G20 2013).

In this paper, we investigate international monetary policyspillovers using a small

open economy (SOE) New Keynesian model. We assess the welfare effects in the

SOE—referred to as “home”—of forward-guidance policies taken by a large trading

partner—referred to as “foreign”—that has been driven to the ZLB by a negative

demand shock.2We model forwardguidance as a calendar-based policy, in which the

policymaker credibly promises to hold the policy rate at the ZLB for several quarters

longer than implied by its usual policy rule (see Del Negro, Giannoni, and Patterson

2012, Carlstrom, Fuerst, and Paustian 2015).3We focus on the best achievable

outcome for home welfare by assuming that the home central bank follows optimal

policy under commitment.

The model features trade and financial linkages that make home welfare depend

on developments in the foreign economy. In particular, our baseline model features

complete international financial markets, perfect exchange rate pass-through, home

and foreign goods that are substitutes, and a negative demand shock that occurs only

in the foreign economy.4These assumptions aim at representing the experience of

Canada and the United States during the GFC.5

To understand how foreign monetary policy affects the welfare in the home

economy, we write the home welfare loss function as the sum of “foreign losses”

and “home central bank losses.” Foreign losses depend purely on foreign variables,

and thus are exogenous to the home economy. By contrast, home central bank losses

depend on the home variables targeted by the home central bank.6Importantly,

home variables—and consequently the policy trade-off faced by the home central

bank—are also influenced by developments in the foreign economy.

Our main finding is that foreign forward guidance improves home welfare as long

as it improves foreign welfare. The intuition is the following. As foreign forward

2. To the extent that monetary easing achievedthrough unconventional measures such as large-scale

asset purchases is thought to be delivered partially through signaling effects about the future intentions of

monetary policymakers (e.g., see Woodford 2012), our modeling strategycould be thought of as serving

as a rough proxy for these measures too.

3. The announcements of the Federal Open Market Committee (FOMC) in 2011 and 2012 can be

characterized (at least to some extent) as examples of calendar-based forward guidance. In August 2011,

the FOMC announced that it expected the federal funds rate to remain at its then exceptionally lowlevel “at

least through mid-2013.” In January 2012, the FOMC prolonged its assessment for how long rates would

need to remain low and stated that it expected them to be at that level“at least through late 2014.” Both an-

nouncements represented an extension of the anticipated duration of the stay at the ZLB of severalquarters.

4. Both home and foreign economies also feature sticky prices and monopolistic competition in

goods markets.

5. We follow Levin et al. (2010) in using negative demand shocks to bring the foreign economy to

the ZLB.

6. In the baseline model, optimal monetary policy implies that the central bank targets the home

output gap and home inflation.

ALEX HABERIS AND ANNA LIPI´

NSKA :1109

guidance stabilizes the foreign output gap and inflation in response to the negative

demand shock, the foreign losses component of overall home losses diminishes: a

healthy trading and financial partner benefits the home economy. By contrast, foreign

forward guidance increases home central bank losses by worsening the policy trade-

off faced by the home central bank. In the baseline model, the home policy trade-off

can be represented as a loss function that comprises home inflation and the home

output gap. We show that foreign forward guidance worsens the trade-off for home

monetary policy,as home inflation increases while home output declines. In particular,

home output falls as an expenditure-switching effect associated with a more appreci-

ated home real exchange rate dominates an aggregate-demand effect resulting from

the higher level of foreign demand. Higher inflation and lower output lead the home

central bank to loosen policy.7All told, we find that home welfare increases because

the reduction in foreign losses is larger than the increase in home central bank losses.

An implication of our finding is that foreign forward guidance reduces welfare in the

home economy only if it reduces foreign welfare. This scenario can materialize if the

foreign central bank overstimulates the foreign economy by promising to hold rates at

the ZLB for too long—resulting in elevatedforeign inflation and a positive output gap.

We consider a number of alternative modeling choices aimed at capturing the

heterogeneous experience of SOEs during the GFC. First, in our baseline model, we

assume that only the foreign economy is hit by a negative demand shock, broadly

resembling, for example, the experience of the US and Canada. In an alternative

calibration of the model, which we label global shock scenario, we assume that both

economies are hit by a shock of equal size. This calibration more closely resembles

the experience of the United States and the United Kingdom. Second, SOEs differ

among each other in some important structural characteristics, such as the extent of

the exchange rate pass-through and the degree of financial integration.8

We find that, for all models considered, foreign forward guidance generally

improves overall home welfare. However, the effect on home central bank losses

depends on the modeling assumptions. In the global shock scenario, the symmetry of

the shock calls for a similar optimal monetary policy response in both the home and

foreign economies. Thus, foreign forward guidance, by stabilizing foreign inflation

and the foreign output gap, also stabilizes home variables. Consequently, and in

contrast to the baseline model, the home policy trade-off improves.

Under imperfect exchange rate pass-through we find that the expenditure-

switching effect is weaker and, at the same time, foreign forward guidance induces

a decline in import price inflation that exacerbates the home policy trade-off.

Hence, the home policy trade-off worsens compared to the baseline model. Finally,

under incomplete financial markets, risk sharing is not perfect, and thus both the

7. Jones, Kulish, and Rees (2019), using an estimated dynamic stochastic general equilibrium (DSGE)

model of the Canadian economy, find that Fed forward guidance increased the length of the stay at the

ZLB for Canada, which is consistent with our theoretical prediction.

8. Economies such as Canada and the United Kingdom have a high degree of exchange rate

pass-through, while others such as Sweden have a relatively low pass-through (Campa and Goldberg

2005, 2008, Forbes, Hjortsoe, and Nenova 2018). Similarly,international financial integration is typically

high for advanced-economy SOEs but lower for emerging-economy SOEs.