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Monetary policy in a dynamic, global

environment
Business Economics, Jan, 1996 by Robert T. Parru
Changes in technology and the surge in international trade have impacted domestic monetary
policy. However, these changes have not weakened the Federal Reserve's ability to affect
aggregate demand, have not exposed U.S. interest rates and monetary policy to undue influence
from abroad nor have they broken the link between monetary policy and domestic inflation.

The theme of this conference is economic forecasting in a dynamic, global environment. I'm sure
that many of the other speakers are going to touch on a number of the changes that have affected
our ability as economists to make forecasts.

And the changes are legion. There's the dramatic advance in technology that has revolutionized
U.S. financial markets. There's the equally dramatic surge in international trade as countries all
over the world have opened their markets to greater crossborder flows of goods and financial
assets.

These changes certainly have an impact on monetary policymaking as well. In fact, some
observers would go even further; they'd say these changes have essentially disarmed monetary
policy, i.e., they question whether the Fed still has the ability to pursue a low-inflation policy in
this dynamic environment. In fact, one commentator pushed the point so far as to call the Fed a
"toothless tiger on inflation."

In this paper, I want to address three questions that arise about monetary policy's effectiveness in
a dynamic, global environment: (1) Have the changes in our domestic financial market weakened
the Fed's ability to affect aggregate demand? (2) has the globalization of financial markets
exposed U. S. interest rates, and hence monetary policy, to undue influence from abroad? and (3)
has global competition broken the link between domestic monetary policy and domestic
inflation? In answering these questions, I hope to convince you of two major points: (1)
Monetary policy certainly is still effective; and (2) the Fed's commitment to lowering inflation is
as strong and as necessary as ever.

CHANGES IN FINANCIAL MARKETS

Let me start by looking at changes in the U.S. financial market and their impact on the Fed's
effectiveness. Over the past two decades, deregulation, vastly improved information and
communications technology, and advances in our understanding of finance have combined to
accelerate the pace of financial innovation.

These innovations have had far-reaching consequences. New instruments and markets reduce the
costs of bringing borrowers and savers together and increase the opportunities to manage the
risk. At the same time, changes in financial markets have affected the links between monetary
policy and the economy.

But have these changes actually altered the Fed's ability to conduct monetary policy? The answer
is a categorical "No."

1. Even with these changes, the Fed still can affect short-term interest rates. That means we still
have an impact on the cost of borrowing from banks, from other intermediaries, and directly in
capital markets.

2. There's no strong evidence that aggregate demand has become any less sensitive to monetary
policy. Let me give you an example from the housing industry that shows how financial
innovations have cut both ways": the elimination of Reg Q deposit ceilings has lessened the
adverse disintermediation effect on the housing industry, but this is to some extent
counterbalanced by the introduction of ARMs, which have arguably increased the price
sensitivity of housing to monetary policy. Furthermore, when we put the issue to the empirical
test, the results indicate that the magnitude of interest-rate changes needed to achieve a given
effect on output is about the same now as it was in the 1960s and 1970s.

3. Perhaps most important, even if continuing financial innovation does make demand less
sensitive to policy, the Fed can always adjust its response to compensate for the change. When
the economy needs to slow down, the Fed can just step a little harder on the brakes; and when it
needs to speed up, it can just push harder on the accelerator.

THE U.S. IN THE WORLD MARKETPLACE

Next, I'd like to look at this country's evolving role in the world marketplace and its effect on the
conduct of U.S. monetary policy. In the past twenty-five years, international trade in goods and
services has burgeoned as the cost of transportation and communication has shrunk and as trade
barriers have fallen. And financial markets have become more global as well, prompted by
deregulation, technology, and ingenuity. Every day, over a trillion dollars' worth of transactions
take place on foreign exchange markets. And we've all heard about the pools of money that race
around the world's stock, bond, and currency markets in search of the highest returns each day.

But does the globalization of financial markets expose U.S. interest rates to undue influence from
road? In other words, does the U.S. economy's openness undermine the Fed's ability to conduct
monetary policy?

Again, the answer is in the negative. And there are three reasons why. Two of the reasons are
related to characteristics of the United States in the global economy. And the third is related to
our policy choice of flexible exchange rates

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