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Contents
Letter from the President

1

Five Years of Research on Globalization and
Monetary Policy: What Have We Learned?

2

T-Shirt’s Journey to Market

18

Financial Frictions Conference

28

Gauging International Shocks and
Their Implications

34

Summary of Activities 2012

42

Working Papers Issued in 2012

44

New Colleagues at the Institute

46

Institute Staff, Advisory Board and
Senior Fellows

47

Published by the Federal Reserve Bank of Dallas, March 2013.
Articles may be reprinted on the condition that the source is
credited and a copy is provided to the Globalization and Monetary Policy Institute, Federal Reserve Bank of Dallas, P.O. Box
655906, Dallas, TX 75265-5906. This publication is available on
the Internet at www.dallasfed.org.

Globalization and Monetary Policy Institute 2012 Annual Report • FEDERAL RESERVE BANK OF DALLAS 1

Letter from the
President

a

s 2012 drew to a close, the popular
media were full of stories about supposed ancient Mayan predictions of
the world ending in December 2012.
The world did not literally end, of course, but the
world in which many of us came of age, where economic activity was predominantly concentrated in
the United States and Western Europe, is undergoing an end of a different sort: Sometime in 2013,
the share of global economic activity accounted
for by emerging market economies—measured on
a purchasing-power-parity basis—will exceed that
of the so-called advanced economies for the first
time.
The forces of globalization unleashed in the
1990s have seen the global center of economic
gravity shift. To the extent that it ever made sense
to think of the United States as a closed economy,
such a worldview is no longer tenable. International trade is more important to us now than
it was 50 years ago. We remain a nation of immigrants, and our institutions of higher learning
continue to attract the best and the brightest from around the world. We invest massive amounts
overseas, even as we borrow to finance private and public consumption. Indeed, arguably the
ability to borrow large amounts from overseas was instrumental in facilitating the excesses
preceding the recent financial crisis.
Five years ago the Dallas Fed established the Globalization and Monetary Policy Institute
to gain a better understanding of these trends. The five-year anniversary seems a good point at
which to take stock of what we have learned and where we need to focus our future research.
The lead article in this year’s annual report outlines some emerging themes in the institute’s
research program, summarizing many (but not all!) of the 137 working papers that institute staff
and affiliated researchers have produced over the past five years (through January 2013).
We embarked on this research program without preconceived answers, but rather in the
spirit of promoting rigorous economic research in international trade, finance and macroeconomics. I believe we have been successful and look forward to building on that success over
the next five years.

Richard W. Fisher
President and CEO
Federal Reserve Bank of Dallas

We invest
massive amounts
overseas, even
as we borrow to
finance private
and public
consumption.

2 Federal Reserve Bank of Dallas • Globalization and Monetary Policy Institute 2012 Annual Report

Five Years of Research on
Globalization and Monetary Policy:
What Have We Learned?
By Mark Wynne

f

It has long been
known that free trade
contributes to higher
standards of living
over time.

ive years ago the Federal Reserve
Bank of Dallas created the Globalization and Monetary Policy
Institute to promote research that
would help us better understand the implications
of globalization for the conduct of monetary policy
in the United States. We are now half a decade
into this research program, and the institute’s 2012
annual report is a fitting place to assess what has
been accomplished over the past five years. The
2007–09 global financial crisis, from which the
world economy is still recovering, shifted a lot of
attention from the broad topic of globalization to
thinking about the causes and consequences of
the financial crisis.1 However, the excesses (or imbalances) that facilitated the global financial crisis
were a manifestation of financial globalization,
and real globalization (in the form of trade linkages) was pivotal in the transmission of the crisis
from the advanced economies to the emergingmarket economies. Likewise, the contours of the
policy response to the crisis were dictated by
globalization. Never before have central banks had
to create such extensive foreign exchange swap
lines to stabilize the financial sector.
Globalization has not gone away, and the
policy challenges it presents remain. In
this essay, I will summarize some
key research themes that have
emerged in the institute’s work.
When globalization began to attract
attention, there was a widespread
perception that its impact on inflation
in advanced economies was in one
direction only—downward. Yet the
first paper we released as part of this

research program, Evans (2007), argued to the
contrary, namely that greater openness to international trade could be associated with higher
equilibrium inflation. While Evans’ result reflects
in part the details of his modeling strategy, what
now seems clear is that the impact of globalization
on inflation is more subtle than first thought. The
“tailwinds” of lower prices of manufactured goods
produced in the rapidly growing emerging-market
economies are offset by the “headwinds” these
countries generate on commodity prices as a result of their voracious demand for raw materials.2
It has long been known that free trade
contributes to higher standards of living over time.
But the form that free trade takes may matter also.
International trade flows made up primarily of
durable goods have very different implications for
how the world economy responds to shocks than
do trade flows of nondurable goods. The channels
through which globalization affects U.S. living
standards are many and varied. For example,
Cavallo and Landry (2010) show that imports of
capital goods have been an important contributor
to U.S. growth since 1967, contributing between 20
and 30 percent to growth in U.S. output per hour.
Before proceeding, it is worth highlighting some of what we have learned over the past
five years. When Federal Reserve Bank of Dallas
President Richard Fisher delivered the Warren
and Anita Manshel Lecture in Foreign Policy at
Harvard University in November 2005, he posed
the questions: “How can economists quantify with
such precision what the U.S. can produce with
existing labor and capital when we don’t know the
full extent of the global labor pool we can access?
Or the totality of the financial and intellectual

Globalization and Monetary Policy Institute 2012 Annual Report • FEDERAL RESERVE BANK OF DALLAS 3

capital that can be drawn on to produce what we
produce? As long as we are able to hold back the
devil of protectionism and keep open international capital markets and remain an open economy,
how can we calculate an ‘output gap’ without
knowing the present capacity of, say, the Chinese
and Indian economies? How can we fashion a
Phillips curve without imputing the behavioral
patterns of foreign labor pools?”
Put differently, is the concept of slack that
is relevant for short-term inflation dynamics in
an open economy domestic or global? When we
began developing this line of argument, we met
with some skepticism. However, our work over the
past five years has shown that it has substantive
content, even if the empirical evidence has been
fragile.3
A second key thing we have learned is the
importance of the international financial system in
propagating and amplifying shocks. We also know
that the form financial integration takes (whether
through debt or equity market integration) matters for the extent to which economic activity
comoves across countries. Global dynamics do
not necessarily emerge from common shocks but
could result from the international transmission of
country-specific shocks. This has major practical
implications—not just for business-cycle synchronization, but also for the conduct of optimal monetary policy. After all, we cannot insure against
common shocks, but country-specific shocks,
in principle, could be insured against. The main
policy debate in that regard is whether “insuring
against them” can be attained in a competitive
environment where each country sets policy for
itself or whether it requires some degree of policy
coordination at a supranational level.
We have developed a more nuanced understanding of exchange rates and exchange rate
mechanisms. We understand now that flexible
exchange rates per se will not insulate a country
from foreign conditions, and we have a better
grasp of the important role that international pricing behavior has on the macro effects of country-

Chart 1
Evolution of International Trade in the U.S.
Total U.S. trade (percent of GDP)
35

30

25

20

15

10

5

0
1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010

SOURCE: Bureau of Economic Analysis.

specific shocks and their transmission across
countries.
At a more general level, we have a better
understanding that in many circumstances it
is misleading to look at the global economy as
the sum of its constituent parts. We know that
economic conditions and policy actions in one
country could be amplified (or dampened)
depending on the feedback from their impact on
the global economy. And that, in turn, depends on
the linkages (financial as well as through trade, immigration, information, etc.) across countries.

Globalization of the U.S. Economy
The basic facts about globalization are well
known.4 Over the past six decades, the share of
imports in U.S. gross domestic product (GDP) has
increased from just over 4 percent for much of the
1950s and 1960s, to around 10 percent for much
of the 1980s and early 1990s, to an average of 16.5
percent during the years 2005–11. Over the same
period, exports as a share of GDP have grown by
a comparable order of magnitude. Chart 1 shows
the evolution of the international trade sector
relative to the size of the U.S. economy. Perhaps

the single greatest manifestation of international
trade’s increased importance for the U.S. economy
is the ubiquity of the “made in China” label on
many of the manufactured goods we now buy. Accounting for less than 1 percent of U.S. imports in
the 1970s, imports from China alone now make up
almost one quarter of U.S. imports. Over the past
two decades, China has become the workshop of
the world, stripping the U.S. in 2010 of its mantle
as the world’s largest manufacturing country.5
Meanwhile, China’s economy has grown at such a
rapid pace that it is now the world’s second-largest
economy and will, in all likelihood, overtake
the U.S. economy in size sometime in the next
decade.6
The flood of cheap manufactured goods from
China and other emerging-market economies is
far from the only or even the most important aspect of globalization. As trade volumes grew in recent decades, so did international flows of capital.
The United States’ total foreign assets increased
from $961 billion in 1982 to $21 trillion in 2011; as
a share of GDP, our foreign assets increased from
29.5 percent in 1982 to 139 percent in 2011. At the
same time that we were investing overseas, we

4 Federal Reserve Bank of Dallas • Globalization and Monetary Policy Institute 2012 Annual Report

were borrowing comparably large amounts: Our
foreign liabilities increased from $722 billion in
1982 to $25.8 trillion in 2011, or from 22.2 percent
of GDP to 171 percent of GDP. In 1989 the U.S.
went from being a net creditor to the rest of the
world to being a net debtor.
And finally, both actual and virtual flows of
labor have been important to the U.S. economy
in recent decades. The so-called second great
migration saw the foreign-born share of the U.S.
population increase from just under 3.5 percent in
1970 to 12.9 percent in 2010; in absolute numbers,
there are now more foreign-born in the U.S. than
during the great migrations of the late 19th and
early 20th centuries. Virtual migration—through
outsourcing of certain tasks previously performed
in the U.S.—has become important also, although
the exact number of U.S. jobs outsourced to other
countries is difficult to measure.
Measuring globalization is tricky. Traditionally, we look to trade or financial flows to quantify
the degree to which a country is globalized. However, as O’Rourke and Williamson (1999) point
out, a better approach is to focus on prices and the
extent to which prices paid within a country deviate from world prices. In the absence of barriers to
trade—whether natural or man-made—the law of
one price should hold. In a seminal paper, Engel
and Rogers (1996) document deviations from the
law of one price in consumer prices in U.S. and
Canadian cities and reveal a significant border
effect. That is, there are greater price differences
between two cities located in different countries
than between two equidistant cities located in the
same country.
Other researchers have looked at the
prices of standardized commodities to measure
deviations from the law of one price or market
segmentation. The Big Mac hamburger sold by
McDonald’s is one such product. For many years,
The Economist newspaper has tracked the prices
of Big Macs in different countries to provide a
rough guide to exchange rate overvaluation or
undervaluation. Landry (2011) uses the data from

The Economist to assess price variations across
cities within countries as well as across national
borders. He shows that price differences across
the U.S. are greater than those observed across
international borders. Crucini and Yilmazkuday
(2009) develop a model of international cities to
quantify the relative importance of trade costs
and distribution (retail) margins in accounting
for deviations from the law of one price in The
Economist data. They find that for the median
good in their sample, trade costs account for 50
percent of the variance of long-run deviations
from the law of one price, while distribution costs
account for only 10 percent.7 The importance of
nontraded goods such as retail inputs in accounting for deviations from the law of one price for
final goods is explored further by Crucini and
Landry (2012). Crucini and Davis (2013) show
that frictions in distribution can make the import
demand elasticity time-varying. Imports and
domestic goods may be close substitutes, implying
a high import demand elasticity, but if inputs used
in distribution are slow to adjust, then the actual
import quantities may be slow to change following
a change in international relative prices like a
change in the nominal exchange rate.
Another apparent deviation from the law
of one price is the positive correlation that some
researchers have documented between the prices
of tradable consumption goods and per capita
incomes. That is, identical products sell for higher
prices in rich countries than in poor countries.
Simonovska (2010) proposes an explanation for
this based on price discrimination by monopolistically competitive firms selling to consumers
with variable price elasticities of demand. Berka
and Devereux (2010) also find substantial and
persistent deviations from the law of one price
in Europe, even among the countries of the euro
zone, and find that the deviations are very closely
tied to relative per capita GDP levels.
But using price data to quantify the extent
of market integration is not without its problems,
as Mutreja et al. (2012) point out. They show that

Globalization and Monetary Policy Institute 2012 Annual Report • FEDERAL RESERVE BANK OF DALLAS 5

rate pass-through to import prices and final goods
prices is one of the most important questions in
international macroeconomics. From a theoretical
perspective, the work of Martínez-García (2007)
shows that the endogenous dynamics of flexible
exchange rates as well as the exchange rate passInternational Pricing
through on prices will be different depending,
Assessing the degree of globalization by
looking at prices leads naturally to thinking about among other things, on the pricing behavior of
how globalization impacts firms’ pricing decisions. firms.
Amstad and Fischer (2009) look at the
Auer and Fischer (2008) look at how international
question
of pass-through of exchange rate
trade with labor-abundant nations such as China,
changes from import prices to consumer prices
India, Indonesia and Brazil affect the pricing
behavior of U.S. firms. They look at the period from but use a novel (event-study) approach to come
up with estimates. They find that the monthly
1997 to 2006 and show that when exporters from
these countries capture a 1.0 percent market share pass-through ratio is about 0.3; that is, for each
in the U.S., producer prices decline by 3.1 percent. percentage point change in the exchange rate,
about 0.3 percent is passed through to consumer
Most of the decline is accounted for by a 2.4 percent increase in productivity and a 0.4 percent de- prices within a month. Auer (2011) focuses on the
cline in markups. Auer, Degen and Fischer (2010) appreciation of the renminbi between 2005 and
2008 to derive estimates of pass-through and finds
look at the same issue from a European perspecpass-through estimates of exchange rate movetive and show that import competition from
ments to import prices of about 0.8. Pass-through
low-wage countries has strong price effects there
as well, especially in the more-advanced countries to U.S. consumer prices is lower, at 0.56. Auer
also finds that exchange rate movements of other
of western Europe.8 For example, when Chinese
exporters capture a 1 percent share of a European U.S. trade partners have much smaller effects on
market, producer prices in that market decline by U.S. import prices and hardly any effect on U.S.
about 2 percent. Moreover, they find that the effect producer prices. Based on his findings, he simulates the effect of a 25 percent appreciation of the
is greatest for imports from China: Import comrenminbi over 10 months and shows that it would
petition from low-wage countries in central and
eastern Europe does not appear to have a negative be equivalent to a temporary increase in the U.S.
Producer Price Index (PPI) inflation rate of about
effect on western European producer prices. De
Blas and Russ (2010) develop a theoretical model 5 percentage points.
Kim et al. (2013) use microdata on U.S.
to illustrate the mechanism that causes markups
import prices to examine pass-through during
to fall in the wake of trade liberalizations.
Competition from imports limits the pricing the renminbi’s 2005–08 appreciation. An and
Wang (2011) use a vector autoregression model
power of domestic producers and thereby affects
with sign restrictions to identify exchange rate
inflation dynamics. Imports also have a more
shocks to examine pass-through rates to import,
direct effect on overall price developments as
consumer and producer prices in nine member
imports make up a larger share of the consumpcountries of the Organization for Economic Cotion basket. Firms selling into foreign markets
operation and Development (OECD). They find
where a different currency is used need to factor
that pass-through is incomplete at both short and
exchange rate developments into their pricing
long horizons and that pass-through is greatest for
decisions. When exchange rates change, import
import prices and smallest for consumer prices.
prices or profit margins change also. Exchange
even when prices are equalized across countries,
significant barriers to trade may exist, and they
argue that information on actual trade flows is also
needed to infer whether markets are integrated.

Competition from
imports limits the
pricing power of
domestic producers
and thereby affects
inflation dynamics.

6 Federal Reserve Bank of Dallas • Globalization and Monetary Policy Institute 2012 Annual Report

They also show that pass-through rates depend
on other features of an economy. Specifically,
pass-through rates are higher the smaller the
economy, the greater the share of imports, the
more persistent are exchange rate movements, the
more volatile is monetary policy and the higher
the inflation rate.
Auer, Chaney and Sauré (2012) show
that, in the European car market, exchange rate
pass-through is larger for low-quality cars than
it is for high-quality cars and develop a model to
account for this observation. Auer and Schoenle
(2012) further explore the role of market structure
in accounting for incomplete exchange rate
pass-through and show—using microdata on U.S.
import prices—that pass-through following movements in the U.S. dollar is up to four times greater
than pass-through following movements in the
currency of U.S. trade partners. They also show
that pass-through following movements in the currency of a U.S trade partner is greater, the greater
the trade partner’s sector-specific market share.
Baxter and Landry (2012) use a novel dataset of
prices set by IKEA to examine pass-through and
find that pass-through rates are low (of the order
of 0.14 to 0.30) but higher for new goods than for
goods already in the catalogs. IKEA is, of course,
the quintessential example of a multiproduct firm
operating in many different international markets.
Bhattarai and Schoenle (2011) document
some stylized facts about how multiproduct firms
set prices using microdata from the U.S. PPI. One
of their key findings is that firms that sell more
goods tend to adjust their prices more
frequently than firms that sell fewer
goods. However, the firms
that sell more

goods also tend to adjust their prices on average
by smaller amounts. Furthermore, price changes
tend to be very synchronized in multiproduct
firms, and this synchronization tends to increase
as the number of goods sold by a firm increases.
These findings on pass-through raise the
question of how we might account for them. Auer
and Chaney (2009) develop a model of quality
pricing to show why exchange rate pass-through
might not be complete. In their model, exporters
sell goods of different qualities to consumers who
have different preferences for quality. The issue
of pricing and pass-through is also addressed by
Landry (2009) using a two-country version of the
state-dependent pricing model of Dotsey, King
and Wolman (1999). He shows that the assumption of state-dependent pricing—as opposed to the
more widely used assumption of time-dependent
pricing—allows the model to better match important features of the aggregate data.

The Global Slack Hypothesis
The debate about globalization and monetary policy—and specifically, about how globalization might impact inflation dynamics—received a
major boost from the working paper by Borio and
Filardo (2007), which showed that in addition to
depending on domestic slack, inflation in many
advanced countries seemed to be responsive
to measures of global slack as well. Subsequent
research by Ihrig et al. (2007) raised questions
about the empirical robustness of Borio and
Filardo’s findings, and some questioned whether
the notion of domestic inflation depending on
foreign resource utilization even made sense
from a theoretical perspective. Milani (2009b)
examines the empirical content of the global slack
idea for the U.S. and finds that globalization can
only explain a small portion of the decline in the
slope of the U.S. Phillips curve. He also finds that
the sensitivity of U.S. inflation to global output is
small. Milani (2009a) also investigates the global
slack hypothesis for the G-7 countries and finds
little evidence in favor of Phillips curve specifica-

Globalization and Monetary Policy Institute 2012 Annual Report • FEDERAL RESERVE BANK OF DALLAS 7

tions that include measures of global slack as
a driving variable. However, he does find some
evidence that global output has a significant effect
on aggregate demand in most countries he looks
at and, through this channel, on domestic inflation
dynamics. Calza (2008) also finds little evidence in
favor of the global slack hypothesis using quarterly
data for the euro area from 1973 through 2003.
Guilloux and Kharroubi (2008) examine globalization’s impact on inflation in a panel of OECD
countries from 1980 to 2005. They show that the
extent to which domestic consumer price index
(CPI) inflation depends on the domestic output
gap declines as intra-industry trade becomes
more important. Martínez-García and Wynne
(2012) present some evidence in favor of the
global slack hypothesis for the U.S. They find that
U.S. inflation at an annual frequency has become
less responsive to domestic slack (measured as
the cyclical component of U.S. GDP) since 1990.
From 1979 through 2010, there is a more significant relationship between U.S. inflation and slack
in the rest of the world than between U.S. inflation
and slack in the U.S. But they also document a
puzzle—the relationship between measures of
foreign slack and U.S. inflation seems to be weaker
since globalization kicked into high gear (that is,
post 1990) than in the period before.
Martínez-García and Wynne (2010) seek
to shed some light on these debates. Working
with the somewhat more general (albeit still very
stylized) version developed in Martínez-García
(2008) of the benchmark open-economy New
Keynesian model that is widely used in central
banks around the world, they derive four important results. First, in theory at least, CPI inflation
in an open economy does depend on the foreign
output gap as well as the domestic output gap.
Second, the importance of the foreign output gap
as a driver of domestic CPI inflation increases the
more the domestic country imports. Third, under
producer currency pricing, one can write the
Phillips curve for domestic CPI inflation either in
terms of the domestic and foreign output gaps or

Chart 2
Synchronization of Business Cycles
Real GDP growth (percent, year/year)
10
8
Rest of world
6
4
2
0
–2
U.S.

–4
–6
’61

’66

’71

’76

’81

’86

’91

’96

’01

’06

’11

SOURCES: Bureau of Economic Analysis; International Monetary Fund; Organization for Economic
Cooperation and Development; national sources; author’s calculations.

with a domestic output gap and a terms-of-trade
variable. That is, at least under certain assumptions about how firms set prices internationally,
the terms of trade ought to fully capture all foreign
influences on domestic inflation. Finally, the concept of the output gap that is consistent with New
Keynesian theory bears little or no relationship
to the output gaps as conventionally measured
using statistical approaches. These four key findings in Martínez-García and Wynne (2010) have
important implications for the empirical literature
on globalization and inflation and how foreign
activity should be captured in empirical Phillips
curve relationships. Martínez-García, Vilán and
Wynne (2012) explore how one might take a fully
articulated general equilibrium model to the data
that would allow an examination of the role of a
theory-consistent measure of the (global) output
gap as a driver of inflation dynamics.

International Transmission
and Business Cycles
With greater economic integration, it is

inevitable that what happens in one part of the
world will have implications for the rest of the
world through financial, trade and other linkages.
Chart 2 shows how economic activity in the U.S.
and the rest of the world tends to move together
over the business cycle. In the recent financial
crisis, economic activity contracted in the U.S.
and around the world. However, after the crisis,
economic activity has tended to recover a lot more
rapidly in the emerging-market economies than in
the advanced economies.
López (2007) examines the role that production sharing through the Mexican maquiladora
industry plays in the synchronization of business
cycles between Mexico and the U.S. manufacturing sector. He shows how a standard, two-sector,
open-economy, real business-cycle model can
match key features of the data for the Mexican maquiladora sector. Arkolakis and Ramanarayanan
(2008) look at the impact of vertical specialization—that is, trade in goods across multiple stages
of production—on business-cycle synchronization
across countries. Intuitively, one might expect that

8 Federal Reserve Bank of Dallas • Globalization and Monetary Policy Institute 2012 Annual Report

Globalization also
increases the global
impact of domestic
policy actions in
response to a crisis.

greater trade volumes between countries would
lead to greater synchronization of business cycles,
but Arkolakis and Ramanarayanan find that additional features are needed to fully account for the
degree of synchronization observed in the data.
Martínez-García and Søndergaard (2008) investigate the role of capital accumulation in smoothing
consumption and buffering a country from external shocks. They argue that the costs of building
new capital and the nature of foreign shocks can
affect to what extent this channel can help insulate
a country and lead to more synchronized cycles.
Davis and Huang (2010) highlight the importance
of strategic pricing by firms selling in domestic
and foreign markets in generating comovement of
production and investment in different countries.
Of particular interest in the wake of the financial crisis of 2007–09 is the role the international
financial system plays in transmitting shocks
across national borders. Devereux and Yetman
(2010) show how the presence of binding leverage
constraints (that is, limits on the ability of households and firms to borrow) can create important
new channels for the international transmission of
shocks through the financial sector. Importantly,
they show that the interaction of these constraints
with diversified portfolios creates a powerful financial transmission mechanism for shocks that is
independent of the size of linkages through international trade channels. Martínez-García (2011)
highlights the importance of the persistence of
shocks in assessing the role of international asset
market incompleteness. His research suggests that
asset market incompleteness has more sizeable
wealth effects on the equilibrium allocation whenever the cycle is driven by persistent investmentspecific technology shocks (that is, shocks that affect the shadow price of productive capital). Ueda
(2010) examines the role of global banks that
engage in cross-border borrowing and lending in
the international transmission of shocks. In Ueda’s
model, business-cycle synchronization increases
as financial globalization intensifies.
Globalization also increases the global

impact of domestic policy actions in response to a
crisis. Davis (2011) shows that the form of international financial integration matters for the degree
of business-cycle comovement. Specifically, he
shows that cross-border credit market integration through debt markets has a positive effect on
business-cycle comovement, while cross-border
capital market integration through debt markets
has a negative effect. The role of global banks in
transmitting shocks across national borders in
the recent financial crisis is also investigated in
Kollmann, Enders and Müller (2011). They find
that while bank capital requirements have little
effect on the international transmission of shocks
and that loan defaults have a negligible contribution to business-cycle fluctuations under normal
circumstances, an exceptionally large loan loss in
one country will induce contractions in economic
activity in all countries. This issue is explored further in Kollmann (2012), who shows that during
the Great Recession, banking shocks accounted
for about 20 percent of the decline in real economic activity in the U.S. and the euro area.
The issue of the international transmission
of shocks during the recent financial crises (the
global financial crisis in 2007–09 and the European sovereign debt crisis in 2010–11) is examined
at length in Chudik and Fratzscher (2012). They
study the transmission of liquidity shocks and risk
shocks and find that emerging-market economies
were much more adversely affected during the
global financial crisis than during the European
sovereign debt crisis.
Yet another potential channel for transmission of shocks across national borders is the
operations of multinational firms. Kleinart, Martin
and Toubal (2012) use microdata on firms operating in France to show that the presence of foreign
affiliates increases the comovement of economic
activity between the region of the affiliate and the
affiliate’s country of ownership.

Migration
One of the more interesting channels

Globalization and Monetary Policy Institute 2012 Annual Report • FEDERAL RESERVE BANK OF DALLAS 9

through which economic developments in one
country are transmitted to other countries is
through emigrants’ remittances. An estimated 11.7
million Mexican nationals live in the U.S., and each
year this community sends between $20 billion
and $25 billion in remittances back to Mexico.9
Similar flows occur between many other pairs of
countries with large immigrant populations (for
example, Germany and Turkey). Coronado (2009)
looks at how these remittance flows change over
the course of the business cycle, focusing on the
flows from the U.S. to Mexico and El Salvador, and
from Germany to Turkey. He shows that remittances tend to go up when economic conditions
in the immigrants’ home country deteriorate.
Interesting, remittances from the U.S. to Mexico
seem to also go up when the U.S. economy contracts, while the remittance flow from the U.S. to
El Salvador and from Germany to Turkey declines
when economic activity in the U.S. and Germany
declines.
Fischer (2009) looks at a different aspect of
immigrants’ interaction with their host country—
their currency use. Contrary to what might be
expected, he finds that demand for high-denomination Swiss banknotes is actually lower in cities
with large immigrant-to-native ratios, and he attributes the use of large-denomination banknotes
to tax avoidance by natives. Fischer (2011) looks at
yet another dimension of how immigrants interact
with their host countries, namely via the housing
market. Other things being equal, one would expect an inflow of immigrants to put upward pressure on housing prices. Fischer asks if it matters
whether the immigrants come from a country that
uses the same language as the host country, the
idea being that immigrants from a non-commonlanguage country are less price sensitive than
immigrants from a common-language country.
Using Swiss data, he finds that an immigrant inflow from a non-common-language country equal
to 1 percent of an area’s population is associated
with a 4.9 percent increase in the price of singlefamily homes, whereas an immigrant inflow from

a common-language country appears to have no
statistically significant effect on house prices.

Optimal Monetary Policy
The traditional specification of the Taylor
rule has central banks setting monetary policy as a
function of the domestic output gap and the deviation of domestic inflation from target. However, it
might be argued that in a more open economy the
central bank should respond to more variables,
such as the exchange rate.
Engel (2009) argues that there is a case for
policy to stabilize exchange rates, as large fluctuations in exchange rates lead to inefficient allocation of resources. The essence of his argument is
that changes in exchange rates that cause relative
prices to deviate from relative costs of production are undesirable from a welfare point of view.
Noting that policymakers cannot always be relied
upon to intervene in foreign exchange markets
in a benign way, he argues that exchange rate
management is best achieved via international
cooperation among policymakers.10
Wang (2010) evaluates the question of
how central banks should adjust interest rates in
response to real exchange rate movements in a
standard two-country dynamic stochastic general
equilibrium (DSGE) model. He finds that when
monetary policy is set to maximize the welfare of
the representative agent, the central bank should
not seek to stabilize exchange rate movements.
Furthermore, he finds that contrary to what other
researchers have argued, there is little to be gained
from international coordination of monetary policies. By way of contrast, Faia and Iliopulos (2010)
argue that optimal monetary policy in a financially
globalized environment calls for central banks to
stabilize the exchange rate as well as output and
the price level.
Evans (2007) examines how the welfaremaximizing inflation rate changes as economies
become more open. He finds that greater openness is associated with higher inflation rates rather
than lower inflation rates. Central to his finding

10 Federal Reserve Bank of Dallas • Globalization and Monetary Policy Institute 2012 Annual Report

Chart 3
Global Current Account Balances
Trillions of U.S. dollars
2
1.6

China
Japan

1.2

U.S.
Germany

.8

Oil exporters
Others

.4
0
–.4
–.8
–1.2
–1.6
–2.
’70

’75

’80

’85

’90

’95

’00

’05

’10

NOTES: Oil-exporting countries are Algeria, Indonesia, Iran, Iraq, Kuwait, Libya, Nigeria,
Oman, Qatar, Saudi Arabia and Venezuela. Sixteen countries are excluded due to data
limitations (Andorra, Cuba, Democratic Republic of the Congo, Kiribati, Liechtenstein,
Marshall Islands, Micronesia, Monaco, Nauru, Palau, North Korea, San Marino, Tuvalu,
United Arab Emirates, Uzbekistan and South Sudan). The remaining 162 United Nations
members compose “Others.”
SOURCE: International Monetary Fund.

Chart 4
Monetary Policy Rates
Percent
7

6

Euro area
U.K.
Japan
Switzerland
U.S.

5

4

3

2

1

0
2006

2007

2008

SOURCE: National central banks.

2009

2010

2011

2012

2013

is his modeling assumption that foreign consumers need to hold domestic currency to be able to
consume domestically produced goods, and the
domestic monetary authority has an incentive
to generate a higher inflation rate as a result to
impose the inflation tax on these foreign holdings.
Cooke (2012) also explores the issue of optimal
monetary policy in a two-country setting and
also finds that greater economic integration is associated with higher long-run inflation. Furthermore, in Cooke’s model environment, there are
increased gains from international cooperation
in the conduct of monetary policy as countries
become more closely integrated.
The issue of how best to conduct monetary policy in a globalized environment is also
addressed at some length in Moutot and Vitale
(2009).

The Financial Crisis
The global financial crisis that began in late
summer 2007 and saw the world teetering on
the brink of a second Great Depression by fall
2008 generated a host of research questions that
will keep the economics profession occupied for
years to come.11 Chart 3 illustrates the extent of
international global capital flows over the past
four decades. Among the factors facilitating the
buildup of excesses that ultimately culminated in
the crisis were the massive global imbalances that
prevailed (and to some extent still do). Ca’ Zorzi,
Chudik and Dieppe (2011) argue that the chances
were minimal that current accounts in the U.S.,
U.K., Japan and China were aligned with fundamentals before the crisis. The role of capital flows
in driving the housing boom(s) that preceded the
crisis is also explored by Sá and Wieladek (2011)
and Sá, Towbin and Wieladek (2011). Sá and
Wieladek find that shocks to capital inflows to the
U.S. driven by foreign savings have a positive and
persistent effect on residential investment and
house prices in the U.S., while monetary policy has
a limited effect on the housing market. Sá, Towbin
and Wieladek do a similar analysis for a broader

Globalization and Monetary Policy Institute 2012 Annual Report • FEDERAL RESERVE BANK OF DALLAS 11

group of OECD countries and find that both types
of shocks matter.
Financial crises are commonly characterized
by adverse feedback loops that seem to make the
associated downturns in economic activity more
severe and the subsequent recoveries weaker
than might otherwise be expected.12 The pace of
recovery from the 2007–09 crisis has been very
weak by historical standards. Davis (2010) develops a model with financial frictions to quantify the
impact of adverse feedback loops where falling
profits and asset values in the real economy lead
to increased loan defaults, which translate into
increased loan losses in the banking sector. This in
turn makes it more difficult for the banking sector
to raise funds, which leads to fewer loans to firms.
Davis finds that adverse feedback loops of this sort
may add as much as 20 percent to the volatility of
economic activity.
Hirakata, Sudo and Ueda (2011) explore the
importance of shocks to the banking sector in a
standard DSGE model of the U.S. economy. They
find that shocks to the net worth of financial intermediaries in their model are important for understanding the dynamics of investment, accounting
for 17 percent of investment variation on average.
However, during the Great Recession, they find
that such shocks were more important, accounting for 36 percent of the variation in investment
between 2007 and 2010.
The financial crisis saw interest rates in most
advanced countries fall to historic lows and once
again raised the question of the appropriate policy
response to a global liquidity trap. Chart 4 shows
monetary policy rates in the advanced economies
since 2006. Devereux (2010) examines the policy
options in a closed-economy environment when
interest rates have fallen to zero and conventional
monetary policy is no longer an option. He shows
that in such an environment, deficit-financed
increases in government spending may be a lot
more expansionary than spending increases
financed by higher taxes. He also shows that a
monetary policy that aims at increasing monetary

aggregates directly may also be effective, even
with fixed interest rates.
Fujiwara et al. (2010) explore the appropriate
policy response in a standard two-country model
where both countries are caught in a liquidity
trap. One of their findings is that it is better from a
welfare point of view to target the price level rather
than the inflation rate (as is standard practice in
most countries now) and that monetary policy in
each country should respond not only to the domestic price level and output gap, but also to the
price level and output gap in the rest of the world.
Cook and Devereux (2011) also investigate policy
options in a global liquidity trap where the natural
real interest rate is below zero in all countries as
a result of a collapse in aggregate demand in the
home country. They find that the optimal cooperative policy response in such an environment
consists of a domestic fiscal expansion combined
with tight monetary policy in the foreign country.
Fujiwara and Ueda (2010) find that fiscal multipli-

ers can exceed 1 when countries are confronted
with a global liquidity trap.
One of the unique features of the recent
crisis was the extent to which central banks had
to provide liquidity not just to domestic financial
institutions but also to international institutions.
At the height of the crisis, a significant portion
of the Federal Reserve’s balance sheet consisted
of loans made under swap arrangements with
foreign central banks to provide dollar liquidity
to banks overseas. And it was not just the Federal
Reserve System that made such loans. Chart 5
(which is adopted from McGuire and von Peter
2009) shows the network of international swap
arrangements created during the crisis to alleviate
foreign currency liquidity crises in different countries. Auer and Kraenzlin (2011) document how
these liquidity programs worked from the Swiss
perspective. During the financial crisis, 80 percent
of the Swiss franc liquidity provided by the Swiss
National Bank was provided to banks domiciled

Chart 5
Central Bank Network of Swap Lines
Reserve Bank
of Australia

Bank of Canada

Reserve Bank of
New Zealand

Bank of Mexico

Central Bank
of Brazil

Monetary Authority
of Singapore

U.S.
Federal
Reserve

Bank of
England

Bank of Japan

People’s Bank
of China

Central Bank
of Sweden
Central Bank
of Norway

Swiss National Bank

Eurosystem

National Bank
of Denmark
Bank of Korea

Central Bank
of Iceland
National Bank of Poland

National Bank
of Hungary

NOTE: The arrows indicate the direction of flows (where known). Light shaded arrows represent U.S. dollars provided to
other central banks; dark arrows represent other currencies (evaluated at average 2008:Q4 exchange rate). Line thickness
is proportional to the size of the swap line.
SOURCE: McGuire and von Peter (2009).

12 Federal Reserve Bank of Dallas • Globalization and Monetary Policy Institute 2012 Annual Report

outside Switzerland. Alberola, Erce and Serena
(2012) look at the stabilizing role of international
reserves during periods of global financial stress
and show how they facilitate disinvestment by
domestic residents.
Davis and Huang (2011) consider the more
general question of whether financial sector
conditions should factor into monetary policy
decisions over and above any impact such conditions might have on inflation or the output gap.
They find that it is optimal for central banks to
respond to fluctuations in the interbank lending
spread that are driven by exogenous financial
shocks and, specifically, that the policy rate should
be reduced by about 66 basis points in response
to a 1 percentage point increase in the interbank
lending spread.
What determines how well policymakers will
respond to a downturn in economic activity? It
may be too early to pronounce the policy response
to the Great Recession a success. (A full evaluation
of the success of the fiscal and monetary policies
adopted in response to the downturn will depend
on whether those policy responses come with
significant long-term costs.) However, Calderón,

Chart 6
Evolution of Global Exports
Trillions of U.S. dollars
20
18
16
14
12
10
8
6
4
2
0
1960

1965

1970

SOURCE: World Bank.

1975

1980

1985

1990

1995

2000

2005

2010

Duncan and Schmidt-Hebbel (2012) show that
institutional quality seems to be an important
determinant of a country’s ability to adopt countercyclical macroeconomic policies.
The ultimate recourse of countries facing
financial crisis is to default on their public debt.
Of course, when governments default, they often
discriminate between different creditors, for
example, defaulting on domestically held but not
foreign-held debt, or vice versa. Erce (2012) looks
at the factors that may lead government to treat
different classes of creditors differently and finds
that factors such as the business sector’s reliance
on foreign capital markets, the soundness of the
domestic banking system and the source of the
liquidity pressures (whether due to a need to meet
external obligations or a need to roll over domestic
debt) all play a role.
The policy response to the global crisis is
unprecedented, with official interest rates in many
countries at or near historic lows (essentially
zero) and central bank balance sheets at record
levels relative to the size of national economies.
White (2012) characterizes the stance of many
advanced-economy monetary policies as “ultra
easy” and raises concerns about the potential unintended consequences of such policies if pursued
for too long.
One of the enduring legacies of the crisis in
many countries will be extraordinarily high levels
of public debt, which many fear that central banks
will be pressured to monetize at some point. Bhattarai, Lee and Park (2012) investigate the relative
contributions of fiscal and monetary policy to
inflation dynamics under different assumptions
about the nature of the regimes governing both.
Under an active monetary and passive fiscal
policy regime, inflation follows closely the path of
the inflation target. However, under an active fiscal
and passive monetary regime, inflation moves in
the opposite direction of the inflation target.
The scale of the collapse in international
trade that accompanied the Great Recession has
attracted much attention, prompting some to talk

Globalization and Monetary Policy Institute 2012 Annual Report • FEDERAL RESERVE BANK OF DALLAS 13

about deglobalization. Chart 6 plots the evolution
of global exports (measured in dollar terms) since
1960. The unprecedented nature of the collapse
in 2008–09 stands out.13 Bussière, Chudik and
Sestieri (2012) use a global vector autoregression
to explore the dynamics of global trade flows between 21 advanced and emerging-market economies. One of their key findings is that shocks to
domestic or foreign demand have much stronger
effects on trade flows than shocks to relative prices. Petropoulou and Soo (2011) develop a simple
analytical model that highlights the importance of
product durability as a mechanism driving trade
collapses in response to shocks. Auer and Sauré
(2011) examine why Swiss exports seem to be so
insensitive to movements in the Swiss franc. They
find that Swiss exports are heavily concentrated
in products that are relatively insensitive to movements in the exchange rate, such as machinery
and pharmaceuticals.

final revised data that were not available to policymakers at the time policy decisions were made
often perform quite differently when evaluated
using the data available in real time. Fernandez,
Koenig and Nikolsko-Rzhevskyy (2011) have
made available a real-time database of 13 major
macroeconomic aggregates for the OECD countries (www.dallasfed.org/institute/oecd/index.
cfm). Their data complement the current OECD
real-time database that starts with 1999, extending
the coverage back to 1962.
Perhaps the most ambitious data creation
project undertaken by the institute over the
past few years has been the database of prices
of products the Swedish retailer IKEA sells in
many countries around the world. Baxter and
Landry (2012) provide detail on the richness of
the dataset and explore its implications for some
central questions relating to the pricing of goods in
international markets.

Data

Conclusions

Good data are essential for any research program. The Globalization Institute has sponsored
the development of three new databases that will
advance our understanding of how the global
economy works. Booms and busts in housing markets were central to the 2007–09 financial crisis
in the U.S. and the ongoing debt crisis in the euro
area. Mack and Martínez-García (2011) constructed an international database on house prices at
a quarterly frequency that covers 21 (mainly advanced) countries starting in 1975. The database
is updated on a regular basis and available to the
public (www.dallasfed.org/institute/houseprice/
index.cfm). One of their main contributions is to
report measures of house prices and household
disposable income that are comparable across
countries.
Policymakers have to make decisions in real
time with flawed and incomplete data that are often revised, and accurate evaluation of forecasting
models and policy rules needs to take account of
this fact. Models and rules that are evaluated using

While economists have been thinking
about the implications of international trade and
finance—“globalization”—since the emergence of
economics as a separate field of scientific inquiry
in the late 18th and early 19th centuries, the passage of time and the progress of technology have
posed new questions and facilitated the development of new tools to address these questions.
When David Ricardo sought to illustrate the gains
from international trade between Britain and
Portugal, he used a simple example of trade in
cloth and wine; 200 years ago, almost all international trade was trade in final goods. Today, most
international trade is trade in intermediate goods,
with the same good crossing international borders
many times on its way to the final consumer.14 In
the early 19th century, most countries relied on
some form of commodity money, and the ideal
of using monetary (or fiscal) policy to stabilize
economic activity was unheard of. Under today’s
fiat money standards, the optimal conduct of
monetary policy takes on a new urgency.

We launched this research program during
the period known as the Great Moderation. At
the time, there were some concerns about “global
imbalances,” but few anticipated the scale of the
crisis that would lead to the Great Recession. Prior
to the financial crisis, the broad consensus in the
central banking community was that inflation
targeting represented the best practice in terms of
monetary policy strategy. The crisis has prompted
some rethinking of that view, and Issing (2011)
argues for broader perspective that includes monetary factors in making central bank decisions.
White (2009) addresses the question of whether
monetary policy should lean against asset price
booms to prevent asset prices from becoming too
elevated or should, instead, simply let asset prices
evolve as they will and clean up the aftermath of
an asset price bust. Both views had their proponents in the central banking community: Policymakers in Europe favored a greater response
of policy to asset price developments, while U.S.
policymakers seemed to prefer the clean-up-themess-afterward approach.
More generally, while we thought we had
a good sense of what globalization might mean
for the conduct of monetary policy in the U.S.
(see, for example, the essay by Wynne 2009), the
Great Recession has thrown up a whole new set
of issues that will be front and center in our future
work. Foremost among these will of course be the
interaction between the financial sector and the
real economy. But we will continue to work on
the central issues related to international pricing,
inflation dynamics, business-cycle synchronization and the optimal conduct of monetary policy
in a more integrated global economy.

Notes
Dating the onset and (more importantly) the ending
of the global financial crisis is somewhat arbitrary.
Strains in the financial system first emerged in late
summer 2007. According to the National Bureau of
Economic Research, economic activity in the U.S.
peaked in December 2007 and the U.S. entered a
recession. The most intense phase of the financial
1

14 Federal Reserve Bank of Dallas • Globalization and Monetary Policy Institute 2012 Annual Report

crisis occurred around the time of the Lehman Brothers failure in September 2008. Global GDP growth
slowed from 5.4 percent in 2007 to 2.8 percent in
2008. In 2009, global GDP contracted by 0.6 percent,
the first absolute decline in global GDP since at least
the 1970s. (International Monetary Fund data on
global GDP do not go back any further.)
2
Davis (2012) highlights the importance of central
bank credibility in anchoring inflation expectations
when commodity prices are subject to large shocks.
3
Martínez-García (2008) elaborated an international
version of the widely used New Keynesian model to
begin to address this issue.
4
This discussion focuses on just the economic dimensions of globalization, although it has important
political and cultural dimensions as well.
5
Measured in current dollars. Source: National Accounts Main Aggregates Database, United Nations
Statistics Division, http://unstats.un.org/unsd/
snaama/dnllist.asp.
6
The date at which the Chinese economy will
become bigger than the U.S. economy depends on
which measure of the relative size of economies one
uses: In purchasing-power-parity terms, the transition will occur sooner. Wynne (2011b) addresses the
question of whether China will ever be as rich as the
U.S. in terms of average living standards.
7
Crucini, Shintani and Tsuruga (2008) use a model
with sticky information to account for deviations from
the law of one price in U.S. and Canadian data.
8
Specifically, Germany, France, Italy, Sweden and
the U.K.
9
For the number of Mexican nationals living in the
United States, see Grieco et al. (2012). Data on
remittances are from HAVER, series N273BW@
EMERGELA.
10
The argument is developed in more (technical)
detail in Engel (2011).
11
Given that the profession continues to study the
causes of the Great Depression of the 1930s, we may
expect the issues raised by the Great Recession of
2008–09 to be with us for many years indeed.
12
See, for example, the discussion in Wynne (2011a).
13
Wynne and Kersting (2009) explore the potential
role of the drying up of trade finance as a contributor
to the collapse.
14
Perhaps the iconic example is the Apple iPhone;
see Xing and Detert (2010).

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——— (2012), “The Effect of Commodity Price
Shocks on Underlying Inflation: The Role of Central
Bank Credibility,” Globalization and Monetary Policy
Institute Working Paper no. 134 (Federal Reserve
Bank of Dallas, December).

De Blas, Beatriz, and Katheryn Niles Russ (2010),
“Teams of Rivals: Endogenous Markups in a Ricardian World,” Globalization and Monetary Policy
Institute Working Paper no. 67 (Federal Reserve Bank
of Dallas, November).
Devereux, Michael B. (2010), “Fiscal Deficits, Debt,
and Monetary Policy in a Liquidity Trap,” Globalization and Monetary Policy Institute Working Paper no.
44 (Federal Reserve Bank of Dallas, April).
Devereux, Michael B., and James Yetman (2010),
“Leverage Constraints and the International Transmission of Shocks,” Globalization and Monetary
Policy Institute Working Paper no. 45 (Federal
Reserve Bank of Dallas, April).
Dotsey, Michael, Robert G. King, and Alexander L.
Wolman (1999), “State-Dependent Pricing and the
General Equilibrium Dynamics of Money and Output,”
Quarterly Journal of Economics 114 (2): 655–90.
Engel, Charles (2009), “Exchange Rate Policies,”
Federal Reserve Bank of Dallas Staff Papers, no. 8.
——— (2011), “Currency Misalignments and Optimal Monetary Policy: A Reexamination,” American
Economic Review 101 (6): 2796–822.
Engel, Charles, and John H. Rogers (1996), “How
Wide Is the Border?,” American Economic Review 86
(5): 1112–25.
Erce, Aitor (2012), “Selective Sovereign Defaults,”
Globalization and Monetary Policy Institute Working
Paper no. 127 (Federal Reserve Bank of Dallas,
September).

16 Federal Reserve Bank of Dallas • Globalization and Monetary Policy Institute 2012 Annual Report

Evans, Richard W. (2007), “Is Openness Inflationary? Imperfect Competition and Monetary Market
Power,” Globalization and Monetary Policy Institute
Working Paper no. 1 (Federal Reserve Bank of Dallas,
October).
Faia, Ester, and Eleni Iliopulos (2010), “Financial Globalization, Financial Frictions and Optimal Monetary
Policy,” Globalization and Monetary Policy Institute
Working Paper no. 52 (Federal Reserve Bank of Dallas, June).
Fernandez, Adriana Z., Evan F. Koenig, and Alex
Nikolsko-Rzhevskyy ( 2011), “A Real-Time Historical
Database for the OECD,” Globalization and Monetary
Policy Institute Working Paper no. 96 (Federal
Reserve Bank of Dallas, December).
Fischer, Andreas M. (2009), “European Hoarding:
Currency Use Among Immigrants in Switzerland,”
Globalization and Monetary Policy Institute Working Paper no. 35 (Federal Reserve Bank of Dallas,
August).
——— (2011), “Immigrant Language Barriers and
House Prices,” Globalization and Monetary Policy
Institute Working Paper no. 97 (Federal Reserve Bank
of Dallas, December).
Fujiwara, Ippei, Tomoyuki Nakajima, Nao Sudo, and
Yuki Teranishi (2010), “Global Liquidity Trap,” Globalization and Monetary Policy Institute Working Paper
no. 56 (Federal Reserve Bank of Dallas, July).
Fujiwara, Ippei, and Kozo Ueda (2010), “The Fiscal
Multiplier and Spillover in a Global Liquidity Trap,”
Globalization and Monetary Policy Institute Working
Paper no. 51 (Federal Reserve Bank of Dallas, June).
Grieco, Elizabeth M., Yesenia D. Acosta, G. Patricia
de la Cruz, Christine Gambino, Thomas Gryn, Luke J.
Larsen, Edward N. Trevelyan, and Nathan P. Walters
(2012), “The Foreign-Born Population in the United
States: 2010,” American Community Survey Reports
(Washington, D.C.: U.S. Census Bureau, May).
Guilloux, Sophie, and Enisse Kharroubi (2008), “Some
Preliminary Evidence on the Globalization-Inflation
Nexus,” Globalization and Monetary Policy Institute
Working Paper no. 18 (Federal Reserve Bank of Dallas, July).

Hirakata, Naohisa, Nao Sudo, and Kozo Ueda (2011),
“Do Banking Shocks Matter for the U.S. Economy?,”
Globalization and Monetary Policy Institute Working
Paper no. 86 (Federal Reserve Bank of Dallas, July).
Ihrig, Jane, Steven B. Kamin, Deborah Lindner, and
Jaime Marquez (2007), “Some Simple Tests of the
Globalization and Inflation Hypothesis,” International
Finance Discussion Paper no. 891 (Washington, D.C.:
Federal Reserve Board, April).
Issing, Otmar (2011), “Lessons for Monetary Policy:
What Should the Consensus Be?,” Globalization
and Monetary Policy Institute Working Paper no. 81
(Federal Reserve Bank of Dallas, April).
Kim, Mina, Deokwoo Nam, Jian Wang, and Jason
Wu (2013), “International Trade Price Stickiness and
Exchange Rate Pass-Through in Microdata: A Case
Study on U.S.–China Trade,” Globalization and Monetary Policy Institute Working Paper no. 135 (Federal
Reserve Bank of Dallas, January).

López, José Joaquín (2007), “Production Sharing and
Real Business Cycles in a Small Open Economy,”
Globalization and Monetary Policy Institute Working Paper no. 5 (Federal Reserve Bank of Dallas,
December).
Mack, Adrienne, and Enrique Martínez-García (2011),
“A Cross-Country Quarterly Database of Real House
Prices: A Methodological Note,” Globalization and
Monetary Policy Institute Working Paper no. 99
(Federal Reserve Bank of Dallas, December).
Martínez-García, Enrique (2007), “A Monetary Model
of the Exchange Rate With Informational Frictions,”
Globalization and Monetary Policy Institute Working Paper no. 2 (Federal Reserve Bank of Dallas,
September).
——— (2008), “Globalization and Monetary Policy:
An Introduction,” Globalization and Monetary Policy
Institute Working Paper no. 11 (Federal Reserve Bank
of Dallas, April).

Kleinart, Jörn, Julien Martin, and Farid Toubal (2012),
“The Few Leading the Many: Foreign Affiliates and
Business Cycle Comovement,” Globalization and
Monetary Policy Institute Working Paper no. 116
(Federal Reserve Bank of Dallas, May).

——— (2011), “A Redux of the Workhorse NOEM
Model With Capital Accumulation and Incomplete
Asset Markets,” Globalization and Monetary Policy
Institute Working Paper no. 74 (Federal Reserve Bank
of Dallas, February).

Kollmann, Robert (2012), “Global Banks, Financial
Shocks and International Business Cycles: Evidence
From an Estimated Model,” Globalization and Monetary Policy Institute Working Paper no. 120 (Federal
Reserve Bank of Dallas, July).

Martínez-García, Enrique, and Jens Søndergaard
(2008), “The Real Exchange Rate in Sticky Price
Models: Does Investment Matter?,” Globalization
and Monetary Policy Institute Working Paper no. 17
(Federal Reserve Bank of Dallas, July).

Kollmann, Robert, Zeno Enders, and Gernot J. Müller
(2011), “Global Banking and International Business
Cycles,” Globalization and Monetary Policy Institute
Working Paper no. 72 (Federal Reserve Bank of Dallas, January).

Martínez-García, Enrique, Diego Vilán, and Mark A.
Wynne (2012), “Bayesian Estimation of NOEM Models: Identification and Inference in Small Samples,”
Globalization and Monetary Policy Institute Working
Paper no. 105 (Federal Reserve Bank of Dallas,
January).

Landry, Anthony (2009), “State-Dependent Pricing,
Local-Currency Pricing, and Exchange Rate PassThrough,” Globalization and Monetary Policy Institute
Working Paper no. 39 (Federal Reserve Bank of
Dallas, September).
——— (2011), “Borders and Big Macs,” Globalization and Monetary Policy Institute Working Paper no.
95 (Federal Reserve Bank of Dallas, November).

Martínez-García, Enrique, and Mark A. Wynne (2010),
“The Global Slack Hypothesis,” Federal Reserve Bank
of Dallas Staff Papers, no. 10.
——— (2012), “Global Slack as a Determinant of
U.S. Inflation,” Globalization and Monetary Policy
Institute Working Paper no. 123 (Federal Reserve
Bank of Dallas, August).

Globalization and Monetary Policy Institute 2012 Annual Report • FEDERAL RESERVE BANK OF DALLAS 17

McGuire, Patrick, and Geotz von Peter (2009), “The
U.S. Dollar Shortage in Global Banking and the
International Policy Response,” BIS Working Paper
no. 291 (Basel, Switzerland, Bank for International
Settlements, October).
Milani, Fabio (2009a), “Global Slack and Domestic
Inflation Rates: A Structural Investigation for G-7
Countries,” Globalization and Monetary Policy
Institute Working Paper no. 33 (Federal Reserve Bank
of Dallas, August).
——— (2009b), “Has Globalization Transformed
U.S. Macroeconomic Dynamics?,” Globalization
and Monetary Policy Institute Working Paper no. 32
(Federal Reserve Bank of Dallas, August).
Moutot, Philippe, and Giovanni Vitale (2009),
“Monetary Policy Strategy in a Global Environment,”
Globalization and Monetary Policy Institute Working Paper no. 29 (Federal Reserve Bank of Dallas,
March).
Mutreja, Piyusha, B. Ravikumar, Raymond Riezman,
and Michael Sposi (2012), “Price Equalization Does
Not Imply Free Trade,” Globalization and Monetary
Policy Institute Working Paper no. 129 (Federal
Reserve Bank of Dallas, September).
O’Rourke, Kevin H., and Jeffrey G. Williamson
(1999), Globalization and History: The Evolution of a
Nineteenth-Century Atlantic Economy (Cambridge,
Mass.: MIT Press).
Petropoulou, Dimitra, and Kwok Tong Soo (2011),
“Product Durability and Trade Volatility,” Globalization and Monetary Policy Institute Working Paper no.
94 (Federal Reserve Bank of Dallas, November).
Sá, Filipa, Pascal Towbin, and Tomasz Wieladek
(2011), “Low Interest Rates and Housing Booms: The
Role of Capital Inflows, Monetary Policy and Financial Innovation,” Globalization and Monetary Policy
Institute Working Paper no. 79 (Federal Reserve Bank
of Dallas, April).
Sá, Filipa, and Tomasz Wieladek (2011), “Monetary
Policy, Capital Inflows and the Housing Boom,”
Globalization and Monetary Policy Institute Working
Paper no. 80 (Federal Reserve Bank of Dallas, April).

Simonovska, Ina (2010), “Income Differences and
Prices of Tradables,” Globalization and Monetary
Policy Institute Working Paper no. 55 (Federal
Reserve Bank of Dallas, July).
Ueda, Kozo (2010), “Banking Globalization and
International Business Cycles,” Globalization and
Monetary Policy Institute Working Paper no. 58
(Federal Reserve Bank of Dallas, August).
Wang, Jian (2010), “Home Bias, Exchange Rate Disconnect, and Optimal Exchange Rate Policy,” Journal
of International Money and Finance 29 (1): 55–78.
White, William R. (2009), “Should Monetary Policy
‘Lean or Clean’?,” Globalization and Monetary Policy
Institute Working Paper no. 34 (Federal Reserve Bank
of Dallas, August).
——— (2012), “Ultra Easy Monetary Policy and the
Law of Unintended Consequences,” Globalization
and Monetary Policy Institute Working Paper no. 126
(Federal Reserve Bank of Dallas, August).
Wynne, Mark A. (2009), “First Steps: Developing a
Research Agenda on Globalization and Monetary
Policy,” Globalization and Monetary Policy Institute
2008 Annual Report (Federal Reserve Bank of Dallas),
4–13.
——— (2011a), “The Sluggish Recovery From the
Great Recession: Why There Is No ‘V’ Rebound This
Time,” Federal Reserve Bank of Dallas Economic
Letter, no. 9.
——— (2011b), “Will China Ever Become as Rich as
the U.S.?,” Federal Reserve Bank of Dallas Economic
Letter, no. 6.
Wynne, Mark A., and Erasmus K. Kersting (2009),
“Trade, Globalization and the Financial Crisis,” Federal Reserve Bank of Dallas Economic Letter, no. 8.
Xing, Yuqing, and Neal Detert (2010), “How the
iPhone Widens the United States Trade Deficit With
the People’s Republic of China,” ADBI Working Paper
no. 257 (Tokyo, Asian Development Bank Institute,
December).

18 Federal Reserve Bank of Dallas • Globalization and Monetary Policy Institute 2012 Annual Report

T-Shirt’s Journey to Market
Highlights Shifting Global
Supply Chain, Economic Ties
By Janet Koech

t

The life of a T-shirt—
from its origins in
a Lubbock, Texas,
cotton field to its
final days in a usedclothing store in
Tanzania—aptly
tells the story of
globalization,
comparative
advantage, trade
regimes, proximity to
market and modern
retailing.

he life of a T-shirt—from its origins in
a Lubbock, Texas, cotton field to its
final days in a used-clothing store in
Tanzania—aptly tells the story of globalization, comparative advantage, trade regimes,
proximity to market and modern retailing.
In the book The Travels of a T-Shirt in
the Global Economy, Georgetown University
economist Pietra Rivoli documents the roles of
three countries on three continents (Chart 1):
the United States, where the raw materials are
produced; China, where cheap labor and flexible
manufacturing practices are tailored to U.S. speedto-market demands; and Tanzania, an east African
country, whose used-clothing industry imports
extensively from the U.S. Along the way, cotton
for the T-shirt is spun, woven, cut and stitched to
U.S. specifications in China. Before the garment
can travel from the factory, it is subject to trade
policies (most formulated in Washington), which
determine sourcing and the quantity allowed
into the country. Once the T-shirt arrives in North
America, a U.S. shopper becomes its first owner.
Years later, after a household spring cleaning,
the now-faded garment is donated to charity,
perhaps to the Salvation Army or Goodwill.1 It
then starts another journey, this time across the
Atlantic to used-clothing stores in parts of Africa
and other developing nations. Here, a second
consumer buys the T-shirt. The single garment
provides a source of income to many during its
lifespan (Rivoli 2009).
The tale of this everyday item sheds light on
the complexities of globalization, mapping the
role of apparel and textiles in emergent economic
development, global shifts in sourcing and the
impact of trade policies.

Apparel and Textiles in
Industrialization
Producing textiles and apparel typically
represents a “starter” opportunity for countries
engaged in export-oriented industrialization. It
involves global production, employment and
trade ties as nations cater to various markets. The
textiles and apparel industries each offer a range
of possibilities, including entry-level positions for
unskilled labor and a broad source of earnings
(Gereffi 2003). The two industries have migrated
from high-income locales to developing (lowincome) ones. Countries importing textiles and
apparel consider not only production costs and
trade agreements, but also the speed to get products to market and flexibility to adapt to retailers’
demands. Supply chains able to react quickly to
changing requirements have gained prominence
over inflexible ones.
Textile and apparel industries—although often thought of interchangeably—are two distinct,
albeit closely related, endeavors. Both represent
important links in the chain of production and
distribution responsible for providing consumers with clothing and related products. Textile
mills manufacture yarn, thread and fabric for
clothing and items such as carpeting, automotive
upholstery, fire hoses, cord and twine. The textile
industry is highly automated and includes yarn
spinning, weaving, knitting, tufting and nonwoven
production.
Apparel manufacture converts textile
industry-produced fabrics into clothing and
other finished goods. The industry’s intermediate processes include cutting, sewing, assembly,
design, pressing, dying and transportation to the
consumer. The largest apparel-related occupation
is sewing machine operator, the most labor-intensive step in production (Mittelhauser 1997).

Globalization and Monetary Policy Institute 2012 Annual Report • FEDERAL RESERVE BANK OF DALLAS 19

Industrialization’s First Rung
Development theory suggests that a poor
country opening up to international trade will
tend to specialize in the export of raw or slightly
processed (primary) products—typically, output
from agriculture, forestry, mining and quarrying
and oil extraction. As income growth exceeds
that of the rest of the world, export specialization
will gradually accompany a shift to manufacturing. Initial manufactured goods will be especially
labor intensive, dependent on a country’s resource
endowment or its population density. Since many
processes in textile and clothing production rely
on an abundance of unskilled labor, textiles and
apparel are among the first items an industrializing economy exports. As national income rises
with growing exports, and the workforce becomes
more skilled, the country moves on to the manufacture of more capital- and technology-intensive
goods it previously imported. In time, another
generation of newly industrializing countries replicates this process, gradually displacing predecessors (Park and Anderson 1991).
Barriers to entry in the clothing industry are
low, and capital requirements are not onerous.
Knowledge requirements vary and tradability of
goods at each level of production is high. Moreover, clothing and textiles have been the source of
rapid, export-led industrialization in several countries (Gereffi and Memedovic 2003). The textile
and clothing value chain is particularly suited to
global production networks since most products
can be exported at each stage of the chain, making
the sector highly trade-intensive and sensitive
to a country’s trade regime. Thus, clothing and
textile industries become a good starting point for
countries with an abundance of low-wage labor
to export their way to development. Textiles’ role
as a forerunner for industrialization goes back to
18th-century Britain, where the mechanization
of cotton processing provided the impetus for the
Industrial Revolution.

Cotton Textile Production—
One-Time Wonder Industry
The Industrial Revolution was a period of
accelerated structural change in world economies,
involving a rapid, technology-driven increase
in industrial output and factory-based activity.

Chart 1
The Travels of a T-Shirt in the Global Economy

Lubbock,
Texas

1

4
3 New York

Washington, D.C.

2

Shanghai,
China

5 Tanzania

SOURCE: ©2005 National Public Radio, Inc. Illustration from NPR® news report titled “Behind Shanghai’s Boom
Is A Simple T-shirt,” originally published on April 27, 2005, and used with permission by NPR.

From its roots in Britain, this transformation spread
to the European continent, North America, Japan
and, ultimately, the rest of the world. The textile
industry played an important role in development
of key industrial innovations that transformed
cotton manufacturing. In 1733, John Kay invented
the flying shuttle, a machine used to weave cloth.
This was accompanied by the improvement of yarn
production using James Hargreaves’ 1764 invention
of the spinning jenny, allowing more than one
ball of yarn or thread to be spun. The jenny relied
on manpower, and it wasn’t long before Richard
Arkwright’s creation of the water frame in 1769 introduced water as an alternate energy resource. The
steam engine, which provided yet another source
of power, enabled rapid development of factories
in places where water power was unavailable. This
greatly increased the output, quality and efficiency
of textile production. Mills sprang up throughout
Britain, and the factory system—the first successful
network of mass production—was created.
Rising textile production brought with it
increased demand for raw cotton, which came
from Britain’s colonies in India, Africa and the
southern U.S. Raw cotton consumption jumped to
267,000 metric tons in 1850 from just over 1,000
tons in 1750. Consumption peaked at 988,000
tons in 1913. Related data indicate that in 1764,
the import of cotton wool (raw cotton) into Britain
totaled 3.9 million pounds; by 1833, it had risen to

303.7 million pounds (Baines 1965).
The early success of the cotton industry and
its contribution to the Industrial Revolution were
highlighted in a British print publication appearing on Sept. 5, 1739 (Baines 1965, pp. 108–09):
“The manufacture of cotton, mixed and
plain, is arrived to so great perfection within these
twenty years, that we not only make enough for
our own consumption, but supply our colonies,
and many other nations of Europe. The benefits
arising from this branch are such as to enable the
manufacturers of Manchester alone to lay out
thirty thousand pounds a year for many years
past on additional buildings. ’Tis computed that
two thousand new houses have been built in that
industrious town, within these twenty years.”
The cotton industry created forward and
backward linkages to other industries that collectively contributed to the Industrial Revolution’s
progress. The advances in cotton textile manufacturing required coal for fuel and iron for new
machinery; the increase in coal and iron mining
dictated improvements in transportation; and the
transportation enhancements, in turn, hastened
development of railroads and steamships. By the
end of the 18th century, the various specializations had coalesced, with the achievements of
one contributing to the success of the other, and
gradually the world’s first Industrial Revolution
took root.

20 Federal Reserve Bank of Dallas • Globalization and Monetary Policy Institute 2012 Annual Report

Industries Spread Beyond Britain

mills were in New England.2 In the early 1900s, U.S.
The industrial achievements of Great Britain cloth production surpassed that of Britain, whose
dominance ended (Chart 2).
extended to Europe and the U.S. in the 19th cenThe New England mills’ labor force, like that
tury. The first American mills lined the banks of
rivers around Massachusetts and New Hampshire, in Britain, was drawn from women, children and,
later, immigrants with few other work alternatives.
and by the late 1800s, the world’s largest textile
As labor costs rose, the industry’s prosperity in the
region did not last, and between 1880 and 1930,
cotton textile production gradually shifted to the
lower-wage southern Piedmont region of the U.S.
Chart 2
Pay in North Carolina during this period was generThe Rise and Fall of Britain’s Cotton Industry
(Exports of cotton goods, 1800–1950)
ally 30–50 percent less than what Massachusetts
Weight, millions of pounds
textile workers received (Wright 1979). Southern
1,200
mills adopted a strong export-oriented market, and
exports to China provided an important engine of
1,000
growth for the regional industry before 1900.3
By the mid-1930s, Japan produced about
800
40 percent of the world’s exports of cotton goods.
Its industry leadership, based on low labor costs
600
and the prevalence of “night work,” doubled textile
machinery productivity. Research on Japanese
400
wages in the early 1900s found mill worker pay
20–47 percent below pay in the U.S. and England
200
(Moser 1930, p. 13).
Japan’s leadership in textile production weak0
ened in the 1950s as new players offered yet-lower
1800 1810 1820 1830 1840 1850 1860 1870 1880 1890 1900 1910 1920 1930 1940 1950
labor costs (Chart 3). By the 1970s, members of
SOURCES: Ellison’s Cotton Trade of Great Britain; Liverpool Cotton Association and the Cotton
the Asian “tiger” economies (Hong Kong, South
Board as reported in Robson (1957), pp. 331–33.
Korea, Taiwan) passed Japan in textile and apparel
exports. They were subsequently supplanted by
Chart 3
less-developed countries and regions with still
The Rise and Fall of Japanese Textile Industry
(Textile and clothing share of exports)
cheaper costs—China, Southeast Asia, Sri Lanka
and the Caribbean.
Percent
40

Flying-Geese Paradigm and Textile
Production Shifts

35
30
25
20
15
10
5
0

9

–7

74

18

–8

80

18

9

9

–9

90

18

9

–0

00

19

9

–1

10

19

9

–2

20

19

9

–3

30

19

9

–5

50

19

9
–6

60

19

9

–7

70

19

7

–8

80

19

NOTE: Data for 1940-49 are unreported, coinciding with the war period.
SOURCES: Yearbook of National Accounts Statistics, United Nations, and others as reported in
Park and Anderson (1991).

The catch-up process of industrialization in
laggard economies where industrial development
is transferred from the leader to the next tier of followers, and then to the next, resembling an inverted
formation of flying geese, was dubbed the “flying
geese model” by Kaname Akamatsu in the 1930s
(Akamatsu 1962). This theory refers to industry
and product life cycle from origination, growth and
decline and the shift from one country or product
to another.
A scatter plot showing changes in consumption of textile production input (raw cotton) as
countries’ income levels advance, with resulting

Globalization and Monetary Policy Institute 2012 Annual Report • FEDERAL RESERVE BANK OF DALLAS 21

Chart 4

Flying Geese Paradigm Illustrates Production Relocation

Cotton consumption, thousands of metric tons

Cotton consumption, thousands of metric tons

1,200

3,000

U.K. 1830–1992

1,000

2,500

800

2,000

600

1,500

400

1,000

200

500

U.S. 1860–1993

0

0
0

5,000
10,000
15,000
Real GDP per capita (in 1990 prices)

0

20,000

5,000
10,000
15,000
20,000
Real GDP per capita (in 1990 prices)

25,000

							

Cotton consumption, thousands of metric tons
500
Taiwan 1950–1998
450

Cotton consumption, thousands of metric tons
900

Japan 1830–1998

800

400

700

350

600

300

500

250

400

200

300

150

200

100

100

50

0

0

4,000

8,000

12,000

16,000

20,000

24,000

0
800

Real GDP per capita (in 1990 prices)

2,800 4,800 6,800 8,800 10,800 12,800 14,800 16,800
Real GDP per capita (in 1990 prices)

Cotton consumption, thousands of metric tons

Cotton consumption, thousands of metric tons

							
500
6,000
South Korea 1950–1998

China 1950–1998

450

5,000

400
350

4,000

300

3,000

250
200

2,000

150
100

1,000

50
0
500

0
2,500

4,500 6,500 8,500 10,500 12,500 14,500
Real GDP per capita (in 1990 prices)

400

900

1,400
1,900
2,400
2,900
Real GDP per capita (in 1990 prices)

3,400

SOURCES: International Historical Statistics: Europe, 1750–2000, by B.R. Mitchell, Palgrave Macmillan, 2003; International Historical Statistics: Africa,
Asia and Oceania, 1750-1988, by B.R. Mitchell, Palgrave Macmillan, 1995; Historical Statistics of the World Economy: 1–2008 AD, by Angus Maddison.

industry shifts, is indicative of the flying-geese
paradigm (Chart 4). The model helps explain the
growth, decline and shift of textile and apparel
industries from developed to developing countries.
When nations produce for export, consumption

of raw materials increases, and over time export
earnings translate into higher incomes and greater
capital accumulation. Production inputs such as
labor become more skilled and more expensive
relative to other nations with cheaper inputs, thus,

22 Federal Reserve Bank of Dallas • Globalization and Monetary Policy Institute 2012 Annual Report

Chart 5
U.S. Textile and Apparel Sourcing Shifts Over Time
Percent
100
90
80
70
60
50
40
30
20
10
0

’90 ’91 ’92 ’93 ’94 ’95 ’96 ’97 ’98 ’99 ’00 ’01 ’02 ’03 ’04 ’05 ’06 ’07 ’08 ’09 ’10 ’11 ’12
Rest of the World

Thailand

Taiwan

Indonesia

Honduras

Cambodia

South Korea

Vietnam
India

Italy

Pakistan

Hong Kong

El Salvador

Bangladesh

China

Canada

Phillippines

Mexico

NOTE: The yellow area represents other countries from which the U.S. imports textiles and
apparel. This group,which accounts for 30 percent or less of U.S. textile and apparel imports,
consists of over 180 countries, each accounting for a small portion of U.S. imports.
SOURCE: U.S. Department of Commerce’s Office of Textiles and Apparel.

leading to a loss of comparative advantage in textile
production. These countries then move to the next
tier of manufactured goods requiring more capital
and skilled labor (up the industrial ladder), and
consumption of textile production inputs drops.
Another country embarks on textile production
until it loses comparative advantage to others that
produce cheaply.

U.S. Textile and Apparel Sourcing
Patterns
The production shift from developing to
developed countries is evident in U.S. textile and
apparel sourcing patterns. Hong Kong, Taiwan
and Korea make the top 10 list of suppliers in the
1990 to 2000 period, but drop out after 2000, with
China, Vietnam and India taking the lead since
2008 (Chart 5). In the U.S., falling employment in
these industries also illustrates movement of pro-

duction offshore. Textile mill employment peaked
at about 1.4 million in 1941, while apparel industry
employment topped out in 1973 at 1.5 million
workers. Today, these sectors each employ fewer
than 250,000 people, with their shares of total
manufacturing similarly declining. In 1939, textile
and apparel employment represented about 10
percent of total U.S. manufacturing. Today, their
share has dropped to around 2 percent (Chart 6).
Surviving industries in the U.S. include the
manufacture of articles for armed forces personnel and certain high-end items. To remain
competitive, enterprises must be extremely
labor-efficient. The use of advanced machinery—
computers and computer-controlled equipment
in designing, patternmaking and cutting—helps
boost productivity. The industry also benefits from
procurement regulations mandating that U.S. military clothing be produced in the United States—a
requirement subsequently extended to cover the
Transportation Security Administration (Bureau
of Labor Statistics 2011).

Behind Global Shifts
The U.S., as one of the largest importers of
textiles and apparel, significantly influences world
markets. U.S. sourcing patterns have changed
over time (see Chart 5), owing to such traditional
considerations as labor, transport and procurement costs, and trade policies. There also are new
factors—speedy product delivery and flexibility to
adapt to changing market demand.
Labor costs have driven relocations of textile
and apparel production—from Britain to the U.S., to
Japan, to the Asian Tigers and, finally, to China and
other developing nations. Government and trade
policies also help determine industry location. As
the newly manufactured T-shirts in Rivoli’s narrative return to the U.S. via the Pacific, the economist
notes that they enter the most complex and most
challenging part of their existence: accessing U.S.
markets. Trade decisions in the U.S. significantly
influence world markets; conversely, international
trade policies impact U.S. sourcing decisions.
As globalization of textiles and apparel has
accelerated, countries have sought to protect
their domestic industries. Textiles and apparel
are among the most heavily protected sectors in
industrialized countries, with the average tariff as

Globalization and Monetary Policy Institute 2012 Annual Report • FEDERAL RESERVE BANK OF DALLAS 23

to buy where quota slack existed, not necessarily where goods were most efficiently produced.
This system shielded many developing countries
from large-supplier competitors, such as China.
After the ATC expired, competition became fierce
and some countries benefited by freely trading
their goods, particularly those nations that could
produce additional product at low cost and gain
market share.
Trade agreements provide an advantage to
suppliers operating in duty-free environments. The
North American Free Trade Agreement (NAFTA),
signed in 1994, is one such arrangement affecting the U.S. textile and apparel industries. NAFTA
eliminated quotas and tariffs on goods produced
in member countries: Mexico, Canada and the

high as 32 percent on clothing, according to the
United Nations (UNDP 2005).
One of the most influential government
policies was the Multi-Fiber Agreement (MFA),
established in 1974 to help manage market
disruptions in developed countries while allowing growth of textile and apparel exports from
developing countries. The agreement consisted
of bilateral arrangements establishing quotas for
certain product lines. In 1995, the Agreement on
Textiles and Clothing (ATC), a 10-year transitional
program for quota removal under the World Trade
Organization (WTO), replaced the MFA. The ATC
regulated quotas until it expired on Dec. 31, 2004.
Under the quota system, a firm’s purchases
from one country were limited, forcing companies

U.S. The Caribbean Basin Preferential Trade Act,
enacted in 2000, is a production-sharing arrangement linking U.S. market access to the Caribbean
Basin with duty- and quota-free products if they
are made of U.S. yarns and textiles. The Dominican
Republic–Central America Free Trade Agreement
offers favorable trade policies and expansion of
regional trade involving Costa Rica, El Salvador,
Guatemala, Honduras, Nicaragua, the Dominican
Republic and the U.S. The African Growth and
Opportunity Act is a U.S. agreement with African
countries for tariff-free trade if production inputs
are sourced from the U.S. or African countries
covered under the agreement.
Such trade arrangements have impacted U.S.
sourcing decisions. For example, China’s integra-

Chart 6
U.S. Textile and Apparel Employment Declines Along with Employment Share
Workers, in thousands

Percent

14
1,600
							
Total employment
1,400

Share of total manufacturing employment

12

Apparel production
1,200

10

1,000
8
800

Textile production

Apparel production

6

600

Textile production
4

400

2

200

0

0
’39

’48

’57

’66

’75

’84

’93

’02

’11

’39

’48

’57

’66

’75

’84

’93

’02

’11

SOURCES: Bureau of Labor Statistics’ Current Employment Statistics Survey reported in Employment, Hours and Earnings, United States, 1909–1990, Volume II, Bulletin 2370 and 1991–1993, Bulletin 2429;
Haver Analytics; author’s calculations.

24 Federal Reserve Bank of Dallas • Globalization and Monetary Policy Institute 2012 Annual Report

Chart 7
U.S. Imports of Textiles and Apparel Shift
(Impact of trade policies on manufacturing)
China’s share of total imports (percent)
50

Mexico’s share of total imports (percent)
16

China joins
with WTO

Mexico joins
NAFTA

45

14
Mexico

40

12
35

10

30

8

25
20

6

15

China

4

10

2

5

0

0

’90

’93

’96

’99

’02

’05

’08

’11

SOURCE: U.S. Department of Commerce’s Office of Textiles and Apparel.

tion into the world trading system through its accession to the WTO at the end of 2001 diminished
Mexico’s textile and apparel industry, which greatly
expanded following NAFTA’s enactment (Chart 7).

Retailers’ Preferences Dictate
Sourcing
Often, discussion of apparel and textile industries shifts focus to national trade flows. These
movements reflect decisions of private parties and
supply chains (retailers and producers of textiles
and apparel) operating within the constraints of
national and international policies. More recently,
retailers’ preferences increasingly dictate national
sourcing patterns.
With new technologies enabling retailers
and suppliers to efficiently track products and
consumer demand, suppliers confront demands
to quickly replenish products and adopt efficient
inventory management while maintaining low
costs. Bar coding and point-of-sale scanning
provide real-time information on product sales;
electronic data interchange tells retailers what inventory to replenish; and automated distribution
centers handle small orders, replacing traditional
warehouse systems used for large bulk shipments (Abernathy et al. 1999). This deployment of

technology to capture information on consumer
demand, reduce inventory surplus, and improve
operations efficiency and profitability is known as
lean retailing.
Lean retailing allows department stores, mass
merchandisers and other retailers to minimize
exposure to demand uncertainty while restraining inventory costs. Widespread adoption of these
strategies means that suppliers must invest in basic
technologies providing information links necessary
for rapid replenishment to retailers. Additionally,
apparel suppliers must devote resources for capital
improvements to package, label, route and quickly
move products from their production centers
directly to retailers. The lean strategy requires frequent shipments sent from suppliers on the basis of
continuous replenishment orders.
For example, an order may be placed with
a manufacturer on a Sunday, after a week’s retail
sales have been tallied. Typically, it might specify a
number of men’s jeans of a given style, color, fabric
weight and finishing treatment and size. The manufacturer’s computer receives the order stipulating
the jeans be placed in particular cartons for each
of the retailer’s stores. The cartons bear bar codes
identifying the specific location where each will
go. The product must be ready for placement on
sales displays with the appropriate price marked.4
The jeans most likely won’t be touched from
the time they leave the manufacturer until they go
on sale Thursday morning. The processes and associated documentation must be fully understood
by the manufacturer and retailers and conform
to industrial standards (Abernathy et al. 1999).
These are significant new costs for suppliers, in
essence shifting the risk of added variability and
quickly changing fashion trends from the retailers
to suppliers. Manufacturers that haven’t adopted
the new technology may end up holding retailer
inventory—a particularly common occurrence
with high-fashion and seasonal items.
Replenishment considerations and the
need for speed to market arising from the new
economics of distribution and production explain
an important portion of sourcing shifts during the
past decade. As lean retailing becomes even more
widespread and suppliers more adept at managing risk, sourcing decisions increasingly include
replenishment considerations. This heightens

Globalization and Monetary Policy Institute 2012 Annual Report • FEDERAL RESERVE BANK OF DALLAS 25

competitiveness among countries able to help
manage retailer inventories.
“In the new quota-free environment, we
will have no choice but to be very discriminating
about our suppliers, selecting only those who can
provide real value to our customer,” said Janet Fox,
then-senior vice president and director of sourcing
for J.C. Penney, during congressional testimony in
2004. “Value does not mean the product with the
cheapest price. It means a supplier that is able to
provide a quality product and service, including
speed to market and supply chain efficiency and
reliability.”

The Next Destination
As production and labor costs inch higher in
China, the primary textile and apparel supplier to
the U.S., global winds may shift, possibly sending
the industry to yet other destinations, including
ones in Africa.5 Indeed, Rivoli’s T-shirt tale ends
up in Africa, as do many articles of clothing and
textiles. Salvation Army and Goodwill stores in the
U.S. take in donations of old clothes. The charities’
stores once sold or gave away much of this inventory, but the domestic supply has grown so large
that only a fraction of the clothing stays in the U.S.
America’s castoffs have therefore found customers
elsewhere in the world.
The U.S. exported nearly 5.5 billion tons of
used clothing and textiles between 2000 and 2010,
becoming the largest used-clothing seller over
the period. Rivoli’s T-shirt arrives in Tanzania,
a big beneficiary; used clothing was Tanzania’s
no. 1 import from the U.S. in 2010 and its no. 2
U.S. import in 2011. Critics charge that an influx
of used clothing has kept Africa from ascending
the traditional development ladder via textile
and apparel manufacture (Frazer 2005). Other
studies show that producing for export rather than
for domestic consumption is the more effective
development path (Ekanayake 1999) and that imports of used clothing present no threat to African
exports (Rivoli 2009). Nonetheless, Africa’s share
of world textile and apparel exports has stagnated
at around 2 percent from 1995 to 2011, even as
other developing countries’ share increased to
58 percent in 2011, from 52 percent in 1995. Developed economies’ share declined to 38 percent
from 44 percent over the same period.

Textiles and apparel were responsible for 61
percent of Lesotho’s total exports in 2011, up from
53 percent in 1995 (Chart 8). These sectors accounted for 20 percent or more of total exports for
four countries—Lesotho, Mauritius, Madagascar
and Tunisia—in 2011, down from five nations in
1995. The sector’s performance across the continent has been mixed, with export shares for previ-

ous major exporters, such as Egypt and Morocco,
dropping in 2011 from 1995 levels.
The continent offers some of the basic ingredients needed for establishment of these industries—
cheap and abundant labor, availability of raw materials (cotton) and favorable trade agreements, such
as the African Growth and Opportunity Act and
the Everything but Arms initiative offering access

Chart 8
Africa’s Export Share of Textiles and Apparel Shows Mixed
Picture of Sector Dominance
53

Lesotho
Mauritius

38
17

Madagascar

27

Tunisia

45

23

Morocco

1995 shares

28

19

2011 shares

13
13

Swaziland
3

Gambia

10

3

Cape Verde

9

Egypt

23

8
3

Kenya
0

61
58

6
10

20

30
40
Percent of total exports

50

60

70

NOTE: Countries are ranked according to their 2011 textile and apparel export shares. The reported
figures are all rounded.
SOURCE: United Nations Conference on Trade and Development.

26 Federal Reserve Bank of Dallas • Globalization and Monetary Policy Institute 2012 Annual Report

to U.S. and European markets. The sector’s growth
in Africa has been hindered by the same factors
limiting the expansion of all manufacturing—lack
of infrastructure, corruption, unstable political
environments, inaccessibility to capital and lack of
regional and foreign market knowledge. Poor roads,
railways and ports create delays, adding to the cost
of importing raw materials and exporting finished
goods. African countries have been disadvantaged
dealing with retailers seeking fast order-to-delivery
cycles. Insufficient transportation networks also
impede intraregional trade and economies of scale
achievable through larger regional production and
market centers. Furthermore, the effects of the MFA
expiration in 2005 exposed smaller, previously
quota-protected economies to fierce competition from large suppliers in Asia. Greater regional
integration could bolster competitiveness through
improved access to materials, product specialization, production sharing and speed to market.

high-income countries to developing economies
with relatively lower pay.
The increasing importance of logistic connections between manufacturing and distribution of textiles and apparel means that supply
chains must exhibit a blend of considerations
reflecting factor prices, transportation costs and
adjustment to the risks of sourcing products in
various locations. The impact of replenishment
and risk-shifting within supply channels alters the
traditional role apparel and textiles can play in
developing countries. The two sectors remain attractive industries in terms of economic development, but assuring their success has become more
complex (Abernathy, Volpe and Weil 2006). It will
be difficult for nations with inadequate infrastructure, located far from major consumer markets or
plagued by political instability to gain competitive
advantage for textile and apparel production even
if they have low wage rates.

Competitive Challenges

Notes

Textiles and apparel were the starting point
of world industrialization. Both industries are
viewed as starter endeavors for development
efforts. Because apparel and textiles are laborintensive, their manufacture has migrated from

The bulk of these donations not sold in stores is
sold to textile recyclers, who resell a portion of their
purchase to used-clothes merchants around the
world.
2
The Amoskeag Manufacturing Co. in Manchester,
N.H., was the largest cotton textile plant in the 19th
century.
3
In the late 1800s, China purchased more than half
of U.S. cloth exports, and more than half of U.S.
exports to China were cotton textiles. In essence,
the Chinese market built Piedmont textile mills. A
century later, floods of cheap cotton clothing from
China are an almost symmetric reversal of previous
trade flows (Rivoli 2009).
4
Under traditional retailing, retailers prepared items
received from manufacturers for display in the stores.
They unpacked the items, affixed price tags and put
them on hangers. However, lean retailing entails
using standards to ensure that products are “floorready” on delivery—that is, on hangers and tagged
and priced when they arrive in stores.
5
China’s hourly manufacturing costs increased 138
percent from 2002 to 2008, according to estimates by
the Bureau of Labor Statistics.

“In the new quota-free environment, we will have
no choice but to be very discriminating about our
suppliers, selecting only those who can provide
real value to our customer. Value does not mean
the product with the cheapest price. It means a
supplier that is able to provide a quality product
and service, including speed to market and
supply chain efficiency and reliability.”
—Janet Fox, then-senior vice president and director of sourcing for J.C. Penney,
testimony before the Subcommittee on Trade, U.S. House Ways and Means
Committee, Sept. 22, 2004.

1

References
Abernathy, Frederick H., John T. Dunlop, Janice H.
Hammond and David Weil (1999), A Stitch in Time
(Oxford: Oxford University Press).

Globalization and Monetary Policy Institute 2012 Annual Report • FEDERAL RESERVE BANK OF DALLAS 27

Abernathy, Frederick H., Anthony Volpe and David
Weil (2006), “The Future of the Apparel and Textile
Industries: Prospects and Choices for Public and
Private Actors,” Environment and Planning 38 (12):
2207–32.
Akamatsu, Kaname (1962), “A Historical Pattern
of Economic Growth in Developing Countries,” The
Developing Economies, preliminary issue, no.1, 3–25.
Baines, Edward (1965), History of the Cotton Manufacture in Great Britain: With a Notice of Its Early
History in the East, and in All the Quarters of the
Globe (London: H. Fisher, R. Fisher and P. Jackson,
orig. pub. 1835).
Bureau of Labor Statistics (2011), “Textile, Textile
Product and Apparel Manufacturing,” Career Guide
to Industries, 2010–11 Edition.
Ekanayake, E.M. (1999), “Exports and Economic
Growth in Asian Developing Countries: Cointegration
and Error-Correction Models,” Journal of Economic
Development 24 (2): 43–56.
Frazer, Garth (2005), “Used-Clothing Donations and
Apparel Production in Africa,” University of Toronto
(Paper presented at the American Economic Association 2005 Annual Meeting, Philadelphia, Jan. 7–9).
Gereffi, Gary (2003), “The International Competitiveness of Asian Economies in the Global Apparel
Commodity Chain,” International Journal of Business
and Society 4 (2): 71–110.

Gereffi, Gary, and Olga Memedovic (2003), “The
Global Apparel Value Chain: What Prospects for Upgrading for Developing Countries?,” (Vienna: United
Nations Industrial Development Organization, May).
Mittelhauser, Mark (1997), “Employment Trends in
Textiles and Apparel, 1973–2005,” Monthly Labor
Review, 120 (8): 24–35.
Moser, Charles K. (1930), The Cotton Textile Industry
of Far Eastern Countries (Boston: Pepperell Manufacturing Co.).
Park, Young-Il, and Kym Anderson (1991), “The Rise
and Demise of Textiles and Clothing in Economic Development: The Case of Japan,” Economic Development and Cultural Change, 39 (3): 531–48.
Rivoli, Pietra (2009), The Travels of a T-Shirt in the
Global Economy: An Economist Examines the Markets, Power and Politics of World Trade (Hoboken,
N.J.: John Wiley & Sons).
Robson, R. (1957), The Cotton Industry in Britain
(London: Macmillan).
United Nations Development Programme (UNDP)
2005, “Flying Colours, Broken Threads: One Year of
Evidence from Asia After the Phase-Out of Textiles
and Clothing Quotas,” Tracking Report, Asia-Pacific
Trade and Investment Initiative (Colombo, Sri Lanka:
UNDP Regional Center, December).
Wright, Gavin (1979), “Cheap Labor and Southern
Textiles Before 1880,” Journal of Economic History
39 (3): 655–80.

28 Federal Reserve Bank of Dallas • Globalization and Monetary Policy Institute 2012 Annual Report

Financial Frictions Conference
Reviews Paths to Monetary Policy Objectives
By J. Scott Davis

t

The recent financial
crisis has precipitated
much new research
on financial frictions’
effects.

he Globalization and Monetary
Policy Institute hosted “Financial
Frictions and Monetary Policy in an
Open Economy,” March 16–17, in
Dallas. The conference brought together theoretical
and empirical researchers to examine how financial
frictions—often using models in which company
balance sheets appear prominently—affect monetary policy in an open economy.
Michael Devereux of the University of British
Columbia and Mark Wynne and Scott Davis of the
Federal Reserve Bank of Dallas organized the meeting. Presenters came from the European Central
Bank (ECB), the Swiss National Bank, the Federal
Reserve Bank of New York and the Dallas Fed as
well as from the University of British Columbia,
New York University, the University of Houston
and the University of Southern California. Paper
discussants were also drawn from a wide range of
institutions, including the University of Montréal,
Georgetown University, the Bank of Canada,
Vanderbilt University, the World Bank and the
Capital Group, an investment management firm.
The recent financial crisis has precipitated
much new research on financial frictions’ effects.
However, it has been mostly limited to a closed
economy framework. While few have studied
financial frictions in an open economy setting, even
fewer have specifically examined the impact of
those frictions on the conduct of monetary policy.
While all papers focused on the conference
theme, each employed different methodologies.
Some papers were empirical, while others were
based on large-scale dynamic stochastic general
equilibrium (DSGE) models. In some papers, the
equilibrium was the solution to a portfolio choice
problem; in some it was the solution to a game
theory problem. When discussing optimal monetary policy, some papers considered the optimal
interest rate rule; others contemplated the optimal

size and frequency of bailouts.

Monetary Transmission
Conference co-organizer Devereux began the
conference with his paper “Nominal Stability and
Financial Globalization” (coauthored with Alan
Sutherland and Ozge Senay of the University of St.
Andrews). A remarkable increase in international
financial integration has occurred over the past
20 to 30 years, the paper notes. At the same time,
a number of countries have adopted monetary
policies focused on domestic inflation and have
achieved a remarkable degree of price stability.
Many authors have argued that global
financial integration has helped produce inflation
stability. With such financial integration, domestic
factors determine less of a country’s income or
wealth. A central bank has less ability to use expansionary monetary policy to boost national income,
even in the short run, and likely will be less tempted
to attempt policies that foster long-run inflation
instability.
Does the line of causation run in the opposite direction, Devereux asked. He contended
that greater monetary and price level stability
in a country attracts investment. Investors are
reluctant to invest in the real or financial assets of a
foreign country with a highly variable inflation rate.
Devereux’s paper sought the analytical solution to a
portfolio choice problem: A household in one country chooses optimal portions of its asset portfolio
for investment in home assets and in foreign assets.
Devereux and coauthors showed that the parameters of the central bank’s policy function appear
in the analytical solution to this portfolio choice
problem. As the weight of foreign central bank
efforts toward inflation stabilization increase, the
domestic household devotes a greater share of its
portfolio to foreign assets. In preliminary empirical
evidence, Devereux showed that bilateral country

Globalization and Monetary Policy Institute 2012 Annual Report • FEDERAL RESERVE BANK OF DALLAS 29

Global financial integration will mean that a central bank has less ability to
use expansionary monetary policy to boost national income, even in the short
run, and likely will be less tempted to attempt policies that foster long-run
inflation instability.
pairs with more inflation stability exhibit greater
bilateral financial integration.
The second paper in the conference, presented by Luca Dedola of the ECB (coauthored with
Giovanni Lombardo and Peter Karadi, also of the
ECB), also examined cross-border financial integration and looked explicitly at central bank policies in
two open economies. The authors sought to learn
if there is any gain from international central bank
cooperation.
In their model, financial intermediaries hold
both home and foreign assets and liabilities. Because of cross-border financial integration, a shock
in one country affects balance sheets of financial
intermediaries in the other country. Thus, in a
model with financial frictions, where the balance
sheets of financial intermediaries can have a major
macroeconomic effect, cross-border financial integration can serve as a mechanism for international
business cycle propagation.
The researchers then use the model to seek
a solution under two different assumptions about
international central bank cooperation. With the
first assumption, central banks in the two countries
cooperate and, thus, each takes into account the
effect of its actions on the foreign economy and foreign welfare. Under the second assumption, each
central bank maximizes welfare in its own country,
taking as given the actions of the other central bank.
Dedola shows that since the degree of international
propagation is high when the balance sheets of
financially constrained intermediaries are closely
intertwined, there is a large benefit from international central bank cooperation. In the model, when
the two central banks cooperate, they will fully offset any financial shocks. However, they find that the
noncooperative equilibrium leads to a suboptimal
degree of central bank intervention because of large
spillovers following a financial shock.
The third paper in the conference, presented

by Simone Meier of the Swiss National Bank, also
examined the implications of cross-border financial
integration, studying its effect on the monetary
transmission mechanism. Some policymakers
have raised the concern that in a world of highly
integrated financial markets, central banks lose the
ability to control the domestic real interest rate, and
thus, monetary policy would have less impact on
domestic output and prices.
To investigate this issue, Meier extends the
standard international New Keynesian DSGE model to incorporate a richer asset-trading framework
where households own both domestic and foreign
assets, with the share of each determined through
solution of a portfolio choice problem.
Meier found evidence that the classic interestrate channel of monetary policy transmission
is reduced with greater international financial
integration. Investment is a function of the longterm interest rate, and the central bank controls the
short-term rate. Greater financial integration means
that global factors rather than shocks to the domestic short-term interest rate influence the long-term
interest rate and, thus, aggregate investment.
But while international financial integration
should reduce the effectiveness of the interest rate
channel of monetary policy transmission, it should
increase effectiveness of both the exchange-rate
and wealth channels. Since the nominal exchange
rate is heavily influenced by the short-term rate,
even in a financially integrated world, the central
bank through monetary policy has control over the
nominal exchange rate. The channel of monetary
transmission is enhanced in a highly integrated
world economy when, through an expansionary monetary policy, the central bank causes an
exchange-rate depreciation and the home country’s
exports become cheaper in the rest of the world.
In addition, when households hold a portfolio of
foreign assets, this exchange-rate depreciation in-

30 Federal Reserve Bank of Dallas • Globalization and Monetary Policy Institute 2012 Annual Report

Greater financial
integration means
that global factors
rather than shocks to
the domestic shortterm interest rate
influence the longterm interest rate
and, thus, aggregate
investment.

creases the real value of their foreign asset portfolio,
making households feel wealthier and stimulating
consumption spending through the wealth effect.
Through simulated impulse responses, Meier
found that the diminished role of the interest-rate
effect and the enhanced role of the exchange-rate
and wealth effects approximately cancel each other
out. Thus, increased international financial integration will reduce the effectiveness of monetary
policy through the classic interest-rate channel
but should not reduce the overall effectiveness of
monetary policy.

Optimal Monetary Policy
The conference’s second session dealt with
optimal monetary policy. The first paper, presented
by Davis of the Dallas Fed (coauthored with Kevin
Huang of Vanderbilt University), asks whether
the central bank should include financial market
variables, such as the interbank lending spread, in its
optimal simple monetary policy rule (involving application of the Taylor rule for suggested policy rates,
for example). The paper looks at this issue in an open
economy setting; the question becomes, does the
central bank want to include both home and foreign
financial market variables in its policy rule?
The answer depends on the source of the financial market imperfection. Specifically, in a model
where incomplete information between borrowers
and lenders gives rise to interbank lending spreads
that depend on variables such as bank debt-to-asset
and loan-loss ratios, the authors distinguish between
endogenous and exogenous changes in the interbank lending spread. Endogenous changes occur
because a real shock, such as a negative productivity
shock, adversely affects bank balance sheets, leading to an increased interbank lending spread. The
authors call this an endogenous shock because the
shock arises in the real sector and affects the financial sector through the endogenous response of real
variables. This contrasts with exogenous changes in
the interbank lending rate, which arise because of exogenous shocks within the financial markets. These
shocks can be interpreted as a sudden increase in
financial market uncertainty leading to interbank
lending rate spikes.
The authors find that it is optimal for the
central bank to respond to exogenous fluctuations in the interbank lending spread but to ignore

endogenous movements. The intuition behind this
is simple: Endogenous fluctuations in the spread
arise because of some shock in the nonfinancial
sector that affects the interbank rate through bank
balance sheets and loan-loss ratios. If the central
bank is already including nonfinancial variables
such as the output gap and the inflation rate in its
policy rule, then the endogenous fluctuation in the
interbank rate contains no new information. When
the central bank is already putting the optimal
weight on the information contained in the output
gap and the inflation rate, putting any weight on
a new variable that contains no new information
would be suboptimal.
Exogenous fluctuations in the interbank
spread arise because of shocks from within the financial sector and contain new information—even
when the weights on these nonfinancial variables
(for example, output gap and the inflation rate
data) have been chosen optimally. Thus, the question of central bank response to financial market
conditions is not as simple as it initially appears. If
fluctuations in the interbank lending spread arise
because of nonfinancial shocks, the central bank
should ignore them. If they arise because of financial sector shocks, the central bank should cut the
risk-free rate in response to a widening spread.
The second, optimal policy paper was presented by Lombardo of the ECB (coauthored with
Marcin Kolasa of the National Bank of Poland and
Warsaw School of Economics). The paper, closely
related to the first paper in this session, looked at
the performance of monetary policy rules in an
open economy with financial frictions.
The authors focused on specific trade-offs
involved with setting optimal monetary policy
and how the presence of financial frictions affects them. The authors compare simple rules
(such as Producer Price Index, or PPI, targeting
or exchange-rate targeting) to optimal monetary
policy. In a model without financial frictions, strict
PPI targeting yields nearly the same outcome as
Ramsey optimal policy. However, they show that
in a model with financial frictions, a trade-off arises
between price level stability and financial stability
following a productivity shock. Strict PPI targeting would maximize price level stability, but also
would exacerbate financial market instability. Thus,
a nearly optimal policy when there is no trade-off

Globalization and Monetary Policy Institute 2012 Annual Report • FEDERAL RESERVE BANK OF DALLAS 31

between price level stability and financial stability
is far from optimal when such trade-off needs to be
taken into account.
The authors also examined issues such as the
currency denomination of debt and how it might
create a trade-off involving price level stability,
exchange-rate stability and financial stability.
When assets are denominated in one currency
and liabilities another, currency fluctuations can
significantly affect balance sheets and financial
stability, which many eastern European countries
discovered during the recent crisis. When liabilities
are denominated in a foreign currency, exchangerate depreciation leads to an increased real value
of those liabilities and deteriorating balance sheets.
Without financial frictions, this doesn’t matter, but
in a model with them, deteriorating balance sheets
will lead to financial instability and widening credit
spreads. In this case, the central bank has an added
incentive to target the nominal exchange rate.
Javier Bianchi of the University of Wisconsin
and New York University presented the third paper
of the session, “Efficient Bailouts?” It asks whether
government policy to transfer money to creditconstrained parties can be optimal during times of
financial stress, even when taking into account the
moral hazard argument that bailouts during a crisis
lead to excessive risk taking during normal times.
Bianchi starts with a simple and intuitive way
of examining the costs and benefits of such intervention. A bailout—a government policy of transferring funds from non-credit-constrained parties to
credit-constrained parties—reduces the severity
of a financial crisis. At the same time, bailouts only
lead to the expectation of such help in the future.
The expectation of bailouts reduces the riskiness
of assuming debt; thus, a legacy of bailouts leads to
excessive borrower risk taking.
Given that there are costs and benefits to
bailouts, there is an optimal size where maximization of benefits minus costs occurs. The point where
that occurs depends on whether the government
imposes a tax on debt, Bianchi argues. Such a tax
will reduce the incentive to hold debt. Thus, if a
policy of bailouts during financial crises leads to a
moral hazard where credit-constrained parties take
on more debt, the tax on debt will temper the incentive to take riskier positions. Quantitatively, Bianchi
finds that when a tax on debt limits this incentive,

a government policy of bailouts during crises is
optimal. Specifically in his model, Bianchi finds
that a government bailout equal to about 2 percent
of gross domestic product is optimal. However,
Bianchi finds that when the bailout policy is not
paired with a moral-hazard-inhibiting tax on debt,
a government bailout policy is not optimal. The
tendency of a policy of bailouts to lead to excessive
risk taking—absent a debt tax—is too strong, and
periodic instances of financial instability without
bailouts are preferable to the moral hazard of regularly bailing out credit-constrained firms.

Banking and International Business
Cycle Transmission
The first paper of the third session was presented by Bent Sorensen of the University of Houston (coauthored with Sebnem Kalemli-Ozcan of
Hoc University and Harvard University and Sevcan
Yesiltas of Johns Hopkins University). The authors
present a new set of stylized facts about banking and
leverage during the 2000–09 period using internationally comparable firm and bank microdata.
Sorensen documents how in the years prior to
the crisis, investment banks in many countries significantly increased their leverage. However, at the

same time, leverage ratios for commercial banks
or nonfinancial firms didn’t notably rise (Chart 1).
Moreover, Sorensen reported, investment banks’
leverage ratio is strongly procyclical. This is also
true for the commercial banking sector, though it’s
driven by procyclical leverage in a few big commercial banks. The median commercial bank did not
have a procyclical leverage ratio in the years leading
to the crisis, he found.
Given that he is compiling a set of stylized
facts from an internationally comparable set of
bank- and firm-level microdata, Sorensen could
compare the behavior of leverage in different
countries with different regulator regimes. Banks in
emerging markets with tighter bank regulation did
not experience the same buildup of leverage in the
years prior to the crisis, he found. Thus, differences
in the regulatory regime across countries were
important for determining international differences
in the debt buildup and procyclicality of leverage in
the past decade.
In the second paper in this session, Linda
Goldberg from the New York Fed (with Nicola
Cetorelli, also of the New York Fed) examined how
liquidity management among multinational banks
led to the international transmission of the recent

Chart 1
Leverage Diverges at Investment, Commercial Banks at
Crisis Onset
Leverage ratio asset/equity
120

Investment banks

100

80

60

40

20
Commercial banks
0

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012

SOURCE: Federal Reserve Flow of Funds.

32 Federal Reserve Bank of Dallas • Globalization and Monetary Policy Institute 2012 Annual Report

financial crisis (Chart 2). Goldberg starts with the
simple observation that global intrabank financial
flows are as large as global interbank flows. When
a large multinational bank experiences funding
problems at one of its affiliates, funds are transferred from within. Thus, liquidity is affected at the
large multinational bank’s other affiliates, leaving
reduced funding for their own customers.
Goldberg looks at large multinational banks
with U.S. affiliates. The hypothesis: During the
financial crisis, parent banks pulled funds from
affiliates in countries unaffected by the crisis. This
led to a liquidity shortage in affiliates that the crisis
hadn’t originally touched, thus leading to rapid
international transmission during the crisis. Specifically, Goldberg found that for every $1 that a foreign
parent bank pulled out of a U.S. affiliate, the affiliate
reduced lending by 40 cents.
The conference’s final paper was presented
by Vincenzo Quadrini of the University of Southern
California (coauthored with Fabrizio Perri of the
University of Minnesota and the Federal Reserve
Bank of Minneapolis). Quadrini also studied rapid
international transmission during the recent
financial crisis. He examined various explanations,
such as a large global adverse shock or propagation
through usual trade and financial channels. None of

Chart 2
Foreign Interest in U.S. Financial System Assets Rises
Amid Globalization
International claims as a percent of U.S. financial system assets
10
9
8
7
6
5
4
3
2
1
0
’77 ’79 ’81 ’83 ’85 ’87 ’89 ’91 ’93 ’95 ’97 ’99 ’01 ’03 ’05 ’07 ’09 ’11

SOURCES: Bank for International Settlements Locational Banking Statistics, Federal Reserve
Flow of Funds

them, he concluded, offers a satisfactory explanation for the spread of the crisis. Quadrini instead
started with the premise that both credit expansions and contractions result from self-fulfilling
expectations. Because of these self-fulfilling expectations, credit expansions or contractions are each
stable equilibria. If investors start to worry about the
creditworthiness of a borrower, they restrict credit,
which ultimately leads to bankruptcy. In this way,
the economy switches between these two equilibria
following a change in investor sentiment.
In a model, Quadrini showed how this process
of switching between two equilibria can lead to the
rapid international transmission of a crisis. In the
model, two countries are linked by integrated financial markets. If investor mood shifts from optimism
to pessimism in one country, borrowers there will
face a liquidity shortage. They will pull funds from
the other country (similar to the way funds are
channeled between affiliate banks in Goldberg’s
paper). This will lead to a drain of liquidity from the
second country, and investors there will turn pessimistic and a credit crunch will become self-fulfilling. Given this possibility for multiple equilibria, an
exogenous change in investor mood in one country
will endogenously lead to a change in investor
mood in the other country, and the extent and
speed of international transmission of a crisis are
far greater than would have been achieved through
financial channels alone, Quadrini showed.

Conclusion
The recent financial crisis raised many
interesting issues related to the role and conduct
of monetary policy in an open economy under
financial frictions.
A crisis, which began as a housing bubble and
subprime crisis in the United States and a handful
of other countries, quickly spread worldwide, raising questions about how international financial
linkages create a truly global recession. About half
the papers in this conference were specifically related to the issue of international financial integration and propagation through integrated financial
markets. The role of liquidity, and specifically that
of banks in the international propagation of the
recent crisis, is not well understood. Goldberg’s
paper on global banks and the international spread
of the crisis helped shed light on this transmission

Globalization and Monetary Policy Institute 2012 Annual Report • FEDERAL RESERVE BANK OF DALLAS 33

The expectation of bailouts reduces the
riskiness of assuming debt; thus, a legacy
of bailouts leads to excessive borrower risk
taking.

mechanism by empirically showing that liquidity
transfers between affiliates of large global parent
banks were in part responsible for propagation of
the recent crisis.
Liquidity, and its larger macroeconomic effect, is a very difficult issue to think about theoretically. Quadrini’s paper on international recessions
showed that, theoretically, this issue of liquidity can
lead to self-fulfilling equilibria, where investors may
switch between self-fulfilling moods of optimism
and pessimism. In a financially integrated global
economy, these self-fulfilling changes in investor
mood have global implications. Work in this area
still leaves unanswered questions, but it definitely
offers an interesting avenue for further research
where this abstract notion of a liquidity crisis can
potentially explain the rapid international transmission of what began as a U.S. subprime lending crisis.
The beginning of the financial crisis in August
2007 led to an unprecedented series of actions by
central banks and policymakers around the world.
Since the only historical precedent for a financial
crisis of this scale was the Great Depression, policymakers did not have a large menu of tested options
from which to choose. Many important responses
to the crisis were decided over the weekend and
were not tested using formal macroeconomic
tools. About half the papers in this conference addressed the issue of optimal monetary policy in a
financial crisis. The papers presented by Davis and
Lombardo specifically looked at the issue of how
the central bank should alter its usual interest-rate
rule in the presence of financial frictions. Lombardo
showed how incorporating financial frictions into
a model opens up a new set of policy trade-offs

affecting optimal monetary policy—such as the
trade-off between price level stability and financial
stability, or the link between exchange-rate stability
and financial stability.
The financial crisis also saw an unprecedented degree of international central bank cooperation. As discussed during the conference, past work
on central bank cooperation that did not include
financial frictions or international financial linkages only found a modest benefit to central bank
cooperation. Policy spillovers were not great, so
cooperation had only a marginal effect. As shown
in the Dedola paper, this finding is reversed when
one considers the role of financial frictions and
international financial linkages. Here, the international spillovers from monetary policy are so large
as to lead to significant benefits from central bank
cooperation. And thus, the papers in this conference discussed not only the conduct of optimal
monetary policy when a central bank needs to take
financial frictions into account, but also the high
degree of international transmission and extent of
policy spillovers. In a world of increasing financial
globalization, future optimal monetary policy
will involve not just one central bank reacting to
domestic financial matters, but cooperation among
policymakers globally.

34 Federal Reserve Bank of Dallas • Globalization and Monetary Policy Institute 2012 Annual Report

Gauging International Shocks
and Their Implications
By Jian Wang

t

he Globalization and Monetary
Policy Institute cosponsored a conference on “International Linkages
in a Globalized World and Implications for Monetary Policy” with the School of International Business Administration at Shanghai
University of Finance and Economics (SHUFE)
and Shanghai Institute of Finance and Law. The
event was held at SHUFE on June 21–22.
The theme was the impact of globalization
on the transmission of shocks across countries
and subsequent implications for policymakers.
Conference organizers were Michael Devereux of
the University of British Columbia, Kevin Huang
of Vanderbilt University, Yuying Jin of SHUFE,
and Jian Wang and Mark Wynne of the Federal
Reserve Bank of Dallas. Presenters’ institutions

included the University of British Columbia,
University of Virginia, New York University, the
International Monetary Fund (IMF) and Federal
Reserve Bank of San Francisco.
During three sessions, authors presented
nine papers examining linkages between economies through trade, offshoring and international
financial markets. The impact of these ties for
conducting monetary policy was also discussed.
In a short policy panel discussion, Benhua
Wei, a former vice chairman of China’s State
Administration of Foreign Exchange (SAFE),
and Wynne, director of the Dallas Fed’s Globalization and Monetary Policy Institute, shared
their views on the global economy, particularly
current policy issues in the United States, China
and the euro area.

Globalization and Monetary Policy Institute 2012 Annual Report • FEDERAL RESERVE BANK OF DALLAS 35

Session I: International Trade,
Offshoring and International
Comovement

ing policy in Ruhl’s model with heterogeneous
firms induces an inefficiency not present in older
models of tariff duties. In those models, antidumping provisions reallocate production toward lessThe first session featured studies on interefficient domestic firms. Moreover, Russ noted
national linkages through trade and offshoring.
that production in Ruhl’s model is reallocated
Kim Ruhl, assistant professor of economics at
New York University’s Stern School, presented his by the antidumping policy toward less-efficient
foreign firms because more-efficient foreign firms
paper “Antidumping in the Aggregate.” The World
will charge higher prices to reduce the probability
Trade Organization (WTO) allows antidumping
of being caught dumping. As a result, less-efficient
duties to punish “unfair” trade practices. The duties are gaining popularity among WTO members, foreign firms can survive. Russ suggested that Ruhl
investigate the size of this inefficiency.
with more than 200 cases initiated annually.
Nan Li, an assistant economics professor at
Antidumping policies, despite their merits in some
Ohio State University and currently at the IMF,
situations, are also often a protectionist tool. For
presented “Factor Proportions and International
instance, antidumping initiations rose during the
Business Cycles,” coauthored with Keyu Jin, a
recent global financial crisis, and countries have
resorted to antidumping claims during earlier eco- lecturer in economics at the London School of
Economics. Jin and Li observe that investment
nomic recessions.1 Previous studies mainly focus
is positively correlated across major advanced
on how antidumping policies lessen competition
economies during business cycles. However, this
between domestic and foreign firms. Because of
pattern is very difficult to replicate in standard inthe complicated game theory involved in antiternational macro models. When the home coundumping models, they represent partial equilibrium and cannot be used to evaluate the aggregate try’s productivity increases relative to that of the
foreign country, investment and production shift
welfare effect of antidumping policy.
from the foreign country to the home country. As
Ruhl incorporates key antidumping propera result, investment increases in the home country
ties into a standard macro trade model with hetbut decreases in the foreign country, generating
erogeneous firms and monopolistic competition.
The model is then used to study the welfare impli- negative cross-country investment comovement.
Jin and Li call this the “resource-shifting effect.”
cations of the antidumping law. In Ruhl’s model,
Jin and Li propose a two-country, multiseceach foreign firm has a higher probability of being
tor model with heterogeneous factor intensities
found guilty of dumping if its price is lower than
to solve this dilemma. The authors first note that
the average price of domestic firms. As a result,
foreign firms increase their prices to decrease the factor intensity (capital-intensive versus laborintensive) varies significantly across sectors in
probability of being accused of dumping. Ruhl
the data. In response, they propose a two-country
calibrates the model to match U.S. data and finds
model, each with capital- and labor-intensive secthat the antidumping policy is equivalent to a 6
tors. When the home country is hit by a favorable
percent tariff.
labor-productivity shock, its labor-intensive sector
Kadee Russ, an assistant economics
expands relative to its capital-intensive sector. As
professor at the University of California at Davis,
provided commentary, noting that the antidump- a result, the prices of capital-intensive goods in-

Because of the
complicated game
theory involved in
antidumping models,
they represent
partial equilibrium
and cannot be used
to evaluate the
aggregate welfare
effect of antidumping
policy.

36 Federal Reserve Bank of Dallas • Globalization and Monetary Policy Institute 2012 Annual Report

crease, encouraging the foreign country to invest
more in the capital-intensive sector. In this case,
investment rises in both countries following an
increase in the home country’s productivity. This
effect can dominate the resource-shifting effect
and generate a positive cross-country correlation of investment, Jin and Li show. The model’s
results are also consistent with some cross-sectional empirical findings in the data.
Wei Liao, an economist at the Hong Kong
Institute of Monetary Research, during her
discussion of the paper recommended that Jin
and Li estimate their sector-specific shocks more
carefully, since their results are highly dependent
on shock calibration. In addition, Liao noticed that
net exports are positively correlated with output
in the model, which is at odds with the data. She
also suggested that the authors investigate the
correlation between trade balance and output at a
sectoral level.
“Threatening to Offshore in a Search Model
of the Labor Market” was presented by Sylvain
Leduc, a research advisor at the San Francisco
Fed. Leduc and his coauthor, David M. Arseneau,
an economist at the Federal Reserve Board,
examine whether the threat of offshoring significantly affects domestic wages and unemployment, using a two-country labor search model.
Many people believe that offshoring hurts the
U.S. economy by depressing domestic wages and
increasing unemployment. However, the threat
of offshoring is not formally modeled in previous
studies, making it impossible to evaluate the effect of offshoring on wages and unemployment.

Arseneau and Leduc introduce search
frictions—in the manner of Diamond-MortensenPissarides—into the labor market in an openeconomy model. In the search framework,
employment relationships generate a surplus
that must be divided between a worker and a
firm. The option of firms to offshore significantly
pressures wages downward in the source country.
In their calibrated model, Arseneau and Leduc
show that the ability of a multinational firm to
offshore domestic production lowers the domestic
wage by nearly 8 percent, even though the actual
amount of offshoring is small (only 1 percent in
the model).
Downward pressure of offshoring on domestic wages is largely a short-run effect, Arseneau
and Leduc emphasize. In the long run, the impact
that the threat of offshoring has on domestic
wages is muted considerably when firm entry and
the capital stock are allowed to adjust freely.
Bo Chen, an assistant professor of economics at SHUFE, discussed the paper. Arseneau and
Leduc’s findings highlight the importance of taking
transitional dynamics into account when evaluating the effects of offshoring policy, Chen said.
He also suggested that the effect of offshoring on
domestic wages and employment may depend
on whether offshoring is vertical or horizontal in
nature.

Session II: International Financial
Linkages and Optimal Monetary
Policy
The conference’s second session showcased
studies and panels on cross-country linkages
through international financial markets and their
implications for conducting monetary policy.
Michael Devereux, an economics professor at
the University of British Columbia, presented
his paper (joint with David Cook of Hong Kong
University of Science and Technology) “The
Optimal Currency Area in a Liquidity Trap.” When
a country joins a single currency area such as the
euro zone, it loses the ability to depreciate its currency to adjust for a negative demand shock in the
country—considered a disadvantage of a single
currency area. Devereux and Cook argue that
this conventional wisdom no longer holds when
a country is in a liquidity trap (that is, when its

Globalization and Monetary Policy Institute 2012 Annual Report • FEDERAL RESERVE BANK OF DALLAS 37

nominal interest rate is at the zero lower bound).
When a country is not in a liquidity trap, its
central bank can carry out expansionary monetary policy in response to country-specific adverse
demand shocks. For example, the real interest rate
declines following a negative demand shock. As a
result, the real exchange rate depreciates to help
absorb the shock. By contrast, when a country
is in a liquidity trap, its real interest rate rises
relative to the foreign country because the home
country’s nominal interest rate cannot be lowered
below zero. In this case, the home country’s real
exchange rate appreciates rather than depreciates, which complicates the response to the shock.
Devereux and Cook show that a single currency
area can solve this problem for a country in such
a scenario. In a standard New Keynesian twocountry model, they show that a negative demand
shock causes a real exchange rate depreciation
independent of whether the country is in a liquidity trap. Devereux and Cook admit that this is not
an argument for a single currency area; however,
they make the case that their model serves as an
illustration that efficient price adjustment is not
guaranteed under a flexible exchange rate regime
following large demand shocks that may push a
country into a liquidity trap.
Kevin Huang, an economics professor at
Vanderbilt University, discussed Devereux and
Cook’s paper. Huang emphasized that transitional
dynamics between normal and liquidity-trap environments may be important when evaluating an
optimal currency area. For instance, if agents anticipate the possibility of reaching the lower bound
in the future, the effects of adverse shocks may be
amplified well before the bound is reached.
“International Contagion Through Leveraged
Financial Institutions,” the second paper of this
session, was presented by Eric van Wincoop, an
economics professor at the University of Virginia.
While the 2008–09 financial crisis originated in
the U.S., asset prices and output dropped sharply
worldwide. Leveraged financial institutions are
believed to have aided the global transmission. Van
Wincoop investigated various transmission mechanisms associated with balance sheet losses in a
simple two-country model. For realistic parameters,
the model cannot account for global transmission
of the financial crisis, either in terms of the size of

When a country is not in a liquidity trap, its
central bank can carry out expansionary
monetary policy in response to countryspecific adverse demand shocks.

Eric van Wincoop of the University of Virginia.

the impact or the extent of transmission.
If leveraged financial institutions weren’t the
transmission channel, what alternatives existed to
account for the 2008–09 financial crisis? Van Wincoop argues that, plausibly, a self-fulfilling spike in
risk occurred on a global scale. Due to the prominent role of the U.S. in global financial markets, the
crisis in the U.S. in the fall of 2008 prompted fear
across countries, which induced a sharp rise in
risk. This, in turn, prompted a sharp drop in asset
prices, confirming initial fears. Van Wincoop and
his coauthors show in another paper that these
changes in risk can be self-fulfilling.2 This line
of theoretical research is consistent with recent
empirical findings that changes in sentiment may
be important in driving business cycles.3

38 Federal Reserve Bank of Dallas • Globalization and Monetary Policy Institute 2012 Annual Report

Scott Davis, an economist at the Dallas Fed,
discussed the paper. Allowing for a closed-form
solution for the extent of international contagion
is one advantage of van Wincoop’s paper, Davis
said. However, several simplifications must be
made to solve for such a solution. The payoff of the
long-term assets in the model does not depend on
the history of default, Davis noted, arguing that the
global transmission of the financial crisis would be
stronger if the model relaxed this simplification.
The session’s last paper, “Exchange Rate
Pass-Through, Firm Heterogeneity and Product
Quality,” by Zhi Yu of SHUFE, explored how
exchange rate pass-through (ERPT) depends on
firms’ productivity heterogeneity and product
Scott Davis of the Federal Reserve Bank of Dallas. quality differentiation. ERPT refers to the percentage change in a country’s prices responding to a 1
percent exchange-rate change. According to the
literature, ERPT is less than 1 in the data. Yu proposes a model with variable markup and product
quality differentiation. In his model, the optimal
price that a firm charges is a variable markup over
a constant cost. When the exchange rate changes,
the firm’s profit margin will change as it passes
along only part of exchange-rate movements. The
firm can also adjust for the quality of its products
in response to exchange-rate movements, further
providing incomplete ERPT. Yu proposes using
Chinese export data in model estimates.
Deokwoo Nam, an assistant economics professor at City University of Hong Kong, discussed
Yu’s work. Nam praised the theoretical analysis
in the paper but expressed concern about model
estimates using the Chinese export data. China
allowed some exchange-rate flexibility only after
2005, potentially making the sample period too
short for use in Yu’s model.

According to standard
international models,
households in fast-

growing economies
should borrow to
finance current

consumption and

repay the money in

the future when they
become relatively
wealthier.

However, monetary policy may also influence
exchange rates by affecting expected current and
future excess returns. Engel, West and Zhu empirically examine these effects in their paper.
Most theoretical open-economy macro models assume that the uncovered interest-rate parity
(UIP) condition holds. Under this setup, the real exchange rate is determined by the expected current
and future real interest rate differentials between
the home and foreign countries. Monetary policy
affects the real exchange rate through its influence
on the real interest rate. However, the failure of UIP
is well documented in the data. In this case, the real
exchange rate is driven by both real interest rate differentials and excess returns. Therefore, the effect of
monetary policy on the real exchange rate can occur through either the real interest rate or the excess
returns channel. Engel, West and Zhu implement
an empirical method to study the effects of these
two channels on U.S. real exchange rates relative to
the G-7 countries and Switzerland. They find that
surprise monetary tightening raises current and
expected real interest rates, which appreciates the
currency. This finding is consistent with the standard open-economy macro models. However, the
effect of monetary shocks on excess returns differs
from currency to currency.
Shu Lin, an economics professor at Fudan
University, discussed the paper, suggesting that the
authors consider different monetary policy rules
to estimate monetary shocks. In addition, he noted
that a country’s monetary policy regime may have
changed throughout the sample period. As a result,
the authors may want to identify these breaks using
econometric methods explored in the literature.
The last two papers of the conference were
devoted to understanding the Chinese economy.
China has recently overtaken Japan as the world’s
Session III: Exchange Rates, Optimal second-largest economy in terms of gross domestic
Monetary Policy and the Chinese
product. A better understanding of China’s econoEconomy
my helps explain its impact on the global economy.
Ken West, an economics professor at the Uni- Nelson Mark, an economics professor at Notre
versity of Wisconsin–Madison, presented “Global Dame University, presented the paper “Demographic Patterns and Household Saving in China”
Interest Rates, Monetary Policy and Currency
(joint with Chadwick C. Curtis and Steven Lugauer
Returns” (joint with Charles Engel and Mian Zhu
of the University of Wisconsin–Madison). In most of Notre Dame University). China’s household
saving rate is high and has risen over the past three
open-economy macro models, monetary policy
decades. This pattern is at odds with China’s rapid
influences exchange rates through its effects on
economic growth during the same period. Accordexpected current and future real interest rates.

Globalization and Monetary Policy Institute 2012 Annual Report • FEDERAL RESERVE BANK OF DALLAS 39

ing to standard international models, households in
fast-growing economies should borrow to finance
current consumption and repay the money in the
future when they become relatively wealthier.
Curtis, Lugauer and Mark argue that
demographic patterns in China can explain high
and rising household savings. Following China’s
one-child policy in the late 1970s, the age distribution of the Chinese population has changed
dramatically. Curtis, Lugauer and Mark highlight
three channels in their model to explain China’s
high saving rate. First, the decline in the number
of dependent children following the one-child
policy has freed up household resources for saving. Second, the share of the prime working age
group (ages 20–63) in China has increased from
46 percent in 1970 to 65 percent today. The prime
working age group is net savers; thus, a population
increase will raise the aggregate saving rate. Third,
the number of retirees per worker is expected to
increase sharply in China because of the one-child
policy. As a result, current workers must save
more to support their future retirement.
Kang Shi, an assistant economics professor
at the Chinese University of Hong Kong, discussed
Curtis, Lugauer and Mark’s paper, noting that high
household saving rates are an interesting phenomenon, but household savings played a limited role
in China’s rising aggregate savings and current account surplus. Indeed, corporate and government
savings accounted for most of the increase in
China’s aggregate savings and its current account
surplus in the past decade.
The final paper of the conference was “A
Model of China’s State Capitalism,” presented by
Yong Wang, an assistant professor of economics at
Hong Kong University of Science and Technology
(joint with Xi Li and Xuewen Liu of Hong Kong
University of Science and Technology). A striking
feature of China’s economy in the past decade is
the sharp profits rise among state-owned enterprises (SOEs). The profit margin of SOEs, measured by the ratio of total profit to sales revenue,
was lower than that of private enterprises in the
1990s. However, this pattern reversed in the 2000s,
an interesting finding considering that SOEs are
usually believed to be less efficient than their private counterparts, based on empirical evidence. In
addition, the profits of China’s SOEs are also highly

correlated with exports, though SOEs account for
a very small share of Chinese exports.
Li, Liu and Wang propose a model with
vertical economic structure to explain these findings. They argue that China’s SOEs monopolize
upstream industries, while downstream industries
are largely open to private competition. Examples
of upstream industries include energy and
telecommunications, which have government-imposed entry barriers and are shielded from private
competition from both home and foreign firms.
Downstream industries, such as textiles and clothing, are internationally traded and subject to international competition. Following China’s accession
to the WTO in 2001, these downstream industries
expanded rapidly due to China’s comparative
advantage in producing labor-intensive, manufactured goods. As a result, upstream SOEs increased
profits by using their monopoly power to extract
greater returns from downstream exporting firms.
Li, Liu and Wang argue that China should remove
entry barriers in its upstream industries to allow
private competition in order to maintain long-run
economic prosperity.

40 Federal Reserve Bank of Dallas • Globalization and Monetary Policy Institute 2012 Annual Report

cross-country correlation of investment and
output. By comparison, investment and output are
highly correlated in the data, especially among advanced economies. Such discrepancies between
the model and the data cast serious doubt on
policy recommendations based on such models.
This problem became more pronounced following
the recent global financial crisis, when the global
economy experienced a remarkably synchronized
recession among most major economies (Chart
1). Most studies focus on either trade or financial
linkages to reconcile the model and the data. For
instance, Jin and Li’s paper uses heterogeneous
factor intensities in the tradable goods sector to
increase the cross-country correlation. Van Wincoop’s paper lists studies using leveraged financial
institutions to generate cross-country correlation.
Despite advances in these studies, several
questions remain in the literature. For both trade
Jian Wang, discussant of Li, Liu and Wang’s
and financial channels, the cross-country spillover
paper, noted that their model is likely realistic of the
of shocks seems much larger than what can be
Chinese economy. He advised, though, that data
justified by the size of the trade and the extent of
may be required to verify several of the model’s
cross-country holdings of financial assets. For exassumptions. For example, Wang mentioned that up- ample, in Jin and Li’s paper, all goods are assumed
stream and downstream industries should be more
to be tradable. Van Wincoop shows that given the
carefully defined and compared with the data. Li, Liu extent of international asset holdings in the data,
and Wang assumed that high profits in the upstream various models fail to replicate the international
industries are due to government-imposed entry
transmission of the financial crisis.
barriers. However, there could be other reasons.
For the future, at least two avenues of study
Wang suggested that the authors do a cross-country appear promising. First, strategic interactions
comparison to verify their assumption.
between domestic and foreign markets may have
played an important role in the cross-country
Conclusion
comovement even though actual trade is limited.
The two-day conference examined internaAs discussed by Arseneau and Leduc, the threat
tional linkages of economies through the channels of of offshoring has significant effects on domestic
international trade, offshoring and financial markets. wages even if the actual offshoring is small. Maybe
Their implications for monetary policy were dissuch interaction could provide a new channel for
cussed, and conference participants also exchanged cross-country transmission of shocks.
views on current issues in the global economy.
Second, as van Wincoop offered at the
Two overarching questions emerged from
conference, changes in self-fulfilling expectations
the conference: First, what are the mechanisms
may have been instrumental in cross-country
of international transmission of shocks from one
comovement. What happens in the U.S. not only
country to another? Second, what is the role of
affects foreign economies through trade and
monetary policy in such transmission channels?
financial markets, but also changes sentiment in
Standard international macro models usuforeign countries. As a result, economies are more
ally fail to replicate international comovement of
correlated than can be justified simply by direct
investment and output. Unless one assumes an
channels such as trade and financial markets. This
unrealistically high correlation of shocks, these
story is consistent with Jian Wang’s recent work
models usually generate small or even negative
on news shocks and changes in sentiment driving

What happens in the
U.S. not only affects
foreign economies
through trade and

financial markets,
but also changes

sentiment in foreign
countries.

Globalization and Monetary Policy Institute 2012 Annual Report • FEDERAL RESERVE BANK OF DALLAS 41

Chart 1
Recession Appears Synchronized in 2008–09
Australia
Austria
Belgium
Canada
Denmark
Finland
France
Germany
Greece
Iceland
Ireland
Italy
Japan
Luxembourg
Mexico
Netherlands
New Zealand
Norway
Portugal
South Africa
Spain
Sweden
Switzerland
Turkey
United Kingdom
United States
1980

1985

1990

1995

2000

2005

2010

NOTE: Bars indicate contraction (peak to trough).
SOURCES: Organization for Economic Cooperation and Development; author’s calculations.

U.S. business cycles.4
Another issue several papers discussed is the
role of an exchange rate in transmitting the effect
of monetary policy. In standard, open-economy
monetary models, an important channel for the
international transmission of monetary shocks is
through the UIP condition. Devereux and Cook
examine a case in which the nominal interest rate
is at its zero lower bound. They find that a flexible exchange rate is destabilizing in response to
demand shocks in this case. This contradicts the
conventional wisdom that exchange rate movements can help absorb demand shocks.
However, UIP’s failure in the data is well
documented. Engel, West and Zhu empirically investigate effects of monetary shocks on exchange
rates through both the UIP condition and excess
returns. They find that the excess-returns channel
is quite different from the UIP channel. Indeed,
exchange-rate movements in the data are mainly
driven by fluctuations in excess returns. Therefore,
it is important to develop a better understanding of how monetary shocks interact with excess
returns. Future empirical and theoretical studies
addressing these topics should further an understanding of the many ways that economies are
connected on a global level.

Notes
1
For example, see “Durable Goods and the Collapse
of Global Trade,” by Jian Wang, Federal Reserve
Bank of Dallas Economic Letter, vol. 5, no. 2, February 2010.
2
See “Self-Fulfilling Risk Panics,” by Philippe
Bacchetta, Cedric Tille and Eric van Wincoop,
American Economic Review, vol. 102, no. 7, 2012, pp.
3674–700.
3
For instance, see “Do Mood Swings Drive Business Cycles and Is It Rational?,” by Paul Beaudry,
Deokwoo Nam and Jian Wang, Federal Reserve Bank
of Dallas, Globalization and Monetary Policy Institute
Working Paper no. 98, December 2011, and NBER
Working Paper no. 17651, November 2011.
4
See note 3.

42 Federal Reserve Bank of Dallas • Globalization and Monetary Policy Institute 2012 Annual Report

Summary of Activities 2012

s

ince its creation in 2007, the
Globalization and Monetary Policy
Institute’s core activities have been
twofold: first, keeping Federal Reserve Bank of Dallas President Richard Fisher and
other senior Bank management apprised of world
economic developments and their implications
for U.S. monetary policy; and second, disseminating cutting-edge research on globalization’s
impact through the institute’s dedicated working
paper series. Prior to each regularly scheduled
Federal Open Market Committee meeting,
institute staff prepare a summary of international
economic conditions as part of a larger briefing
book. Institute staff also regularly brief the Bank’s
board of directors, supply speech material to
senior management, deliver their own speeches
and participate in other ways in the Bank’s various
economic outreach programs.
On the research front, as of year-end 2012,
the institute had circulated 134 papers in its working paper series, and many of these papers have
since been published in peer-reviewed journals.
The ultimate measure of a paper’s quality is whether and where it is published and how frequently
it is cited. In the interim, a reasonable proxy for
impact is the frequency with which papers are
downloaded from the Bank’s website. Chart 1
uses data from the RePEc (Research Papers in
Economics) database to track abstract views and
downloads for the institute’s working paper series
since the series began in fall 2007. We see a steady
growth in both abstract views and downloads (as
we might expect, given the steady additions to the
series over the years). While total downloads were
off slightly in 2012 (1,963 versus 2,246 in 2011),
abstract views were up (from 3,991 to 4,653).
We made progress on other fronts as well,
with institute staff presenting their work at a variety of research forums, moving papers through the
publication process and initiating new projects.
We also deepened our global network of research
associates.

Academic Research
Alexander Chudik had three papers accepted for publication during the year: “Thousands
of Models, One Story: Current Account Imbalances in the Global Economy,” (with M. Ca’ Zorzi
and A. Dieppe) published in Journal of International Money and Finance; “Aggregation in Large
Dynamic Panels,” (with M.H. Pesaran) accepted
for publication in Journal of Econometrics; and
“A Simple Model of Price Dispersion,” published
in Economics Letters. Enrique Martínez-García
and Mark Wynne’s paper “Bayesian Estimation
of NOEM Models: Identification and Inference
in Small Samples” was accepted for publication
in Advances in Econometrics. Janet Koech and
Mark Wynne’s paper “Core Import Price Inflation
in the United States” was accepted for publication
in Open Economies Review. At year end, staff
had papers under review at Journal of Political
Economy, Journal of International Economics, Journal of Monetary Economics, Journal of
Applied Econometrics, B.E. Journal of Macroeconomics, European Economic Review and
Quarterly Journal of Economics.

Conferences
The institute organized two conferences
during 2012. The first, “Financial Frictions and
Monetary Policy in an Open Economy,” was
organized by Scott Davis, Michael Devereux and
Mark Wynne and held at the Dallas Fed in March.
The second, “International Linkages in a Globalized World and Implications for Monetary Policy,”
was jointly organized with Shanghai University of
Finance and Economics and Shanghai Institute
of Finance and Law, and held in Shanghai in
June. Summaries of the papers presented at both
conferences are included elsewhere in this annual
report.
As in previous years, staff have been active in
presenting their work in external forums. Institute
staff presented their research at a variety of conferences in 2012, including Bank for International
Settlements, Midwest Macroeconomics Meetings,

Globalization and Monetary Policy Institute 2012 Annual Report • FEDERAL RESERVE BANK OF DALLAS 43

European meetings of the Econometric Society,
Federal Reserve Bank of San Francisco annual Pacific Basin Research Conference, Federal Reserve
System Committee on International Economic
Analysis, Hong Kong Institute for Monetary Research’s Summer Workshop, Southern Economic
Association meetings, University of Texas at
Arlington, Vanderbilt University, Ohio University
and the annual meeting of the Western Economic
Association.

Bank Publications
Institute staff contributed six articles to the
Bank’s Economic Letter publication during the
year: “Increased Real House Price Volatility Signals Break from Great Moderation” (by Adrienne
Mack and Enrique Martínez-García); “Economic
Rebounds in U.S. and Euro Zone: Deceivingly
Similar, Strikingly Different” (by Anthony Landry
and Carlos E.J.M. Zarazaga); “China’s Slowdown
May Be Worse Than Official Data Suggest” (by
Janet Koech and Jian Wang); “One-Size-Fits-All
Monetary Policy: Europe and the U.S.” (by Mark
Wynne and Janet Koech); “Bringing Banking
to the Masses, One Phone at a Time” (by Janet
Koech); and “Inflation Expectations Have Become
More Anchored Over Time” (by Scott Davis). The
Bank’s Economic Letter and this annual report
are intended to disseminate research to a broader
audience than technical experts in economics.
Of particular note in 2012 was the selection of
Janet Koech’s essay “Hyperinflation in Zimbabwe”
(published in the institute’s 2011 annual report)
for inclusion in the Recommendations for Further
Reading section of the spring 2012 edition of the
American Economic Association’s Journal of Economic Perspectives. Finally, Alexander Chudik’s
paper “How the Global Perspective Can Help Us
Identify Structural Shocks” (with Michael Fidora)
was published in the Bank’s Staff Papers series.

People
Two staff members spent the spring semester on leave at academic institutions. Anthony

Chart 1
Institute Working Papers Draw Increased Attention
600

500
Abstract views
400

300

200

100
Downloads
0

2007

2008

2009

2010

2011

2012

SOURCE: Research Papers in Economics (RePEc) database, http://logec.repec.org/scripts/seriesstat.
pf?item=repec:fip:feddgw (accessed: Feb. 25, 2013).

Landry spent the semester at the University of
Pennsylvania’s Wharton School, and Enrique
Martínez-García taught at the University of Texas
at Austin. Shushanik Papanyan visited the institute
in the spring to work on a project to develop global
economic indicators. We also hosted two PhD
interns over the summer: Ayse Kabukçuoglu from
UT Austin and Sarah Le Tang from Brandeis. Payton Odom left the institute early in the summer to
take up a Fulbright scholarship in Mexico. Valerie
Grossman—a recent SMU graduate—took his
place. A recent University of Iowa PhD graduate,
Michael Sposi, joined us as a new staff member
at the beginning of September, filling the opening
left by the departure of Simona Cociuba last year.
Jian Wang joined the editorial board of Pacific
Economic Review.
This year we recruited 20 new research associates to our network: Javier Bianchi (University
of Wisconsin–Madison), Hafedh Bouakez (HEC
Montréal), Bo Chen (Shanghai University of
Finance and Economics), Hongyi Chen (Hong
Kong Institute for Monetary Research), Yin-Wong

Cheung (University of California, Santa Cruz/
City University of Hong Kong), Dudley Cooke
(University of Exeter), Roberto Duncan (Ohio
University), Aitor Erce (Bank of Spain), Pedro Gete
(Georgetown University), Yi Huang (International
Monetary Fund), Charles Ka Yui Leung (City
University of Hong Kong), Nan Li (Ohio State
University), Shu Lin (Fudan University), Tuan
Anh Luong (Shanghai University of Finance and
Economics), Césaire Meh (Bank of Canada),
Simone Meier (Swiss National Bank), Deokwoo
Nam (City University of Hong Kong), Vincenzo
Quadrini (University of Southern California), Bent
E. Sorensen (University of Houston) and Cédric
Tille (Graduate Institute of International Development Studies).

44 Federal Reserve Bank of Dallas • Globalization and Monetary Policy Institute 2012 Annual Report

Working Papers Issued in 2012
All institute working papers are available on the Dallas Fed
website at www.dallasfed.org/institute/wpapers/.

No. 104

No. 112

Optimal Monetary Policy in a Two Country
Model with Firm-Level Heterogeneity

A Simple Model of Price Dispersion

Alexander Chudik

Dudley Cooke

No. 113
No. 105
Bayesian Estimation of NOEM Models:
Identification and Inference in Small Samples

Enrique Martínez-García, Diego Vilán and
Mark Wynne

No. 106
Financial Markets Forecasts Revisited: Are
They Rational, Herding or Bold?

Hedging Against the Government: A Solution
to the Home Asset Bias Puzzle

Tiago C. Berriel and Saroj Bhattarai

No. 114
Are Predictable Improvements in TFP
Contractionary or Expansionary: Implications
from Sectoral TFP?

Deokwoo Nam and Jian Wang

Ippei Fujiwara, Hibiki Ichiue, Yoshiyuki Nakazono
and Yosuke Shigemi

No. 115

No. 107

Does Foreign Exchange Intervention Volume
Matter?

Liquidity, Risk and the Global Transmission of
the 2007–08 Financial Crisis and the 2010–11
Sovereign Debt Crisis

Rasmus Fatum and Yohei Yamamoto

Alexander Chudik and Marcel Fratzscher

The Few Leading the Many: Foreign Affiliates
and Business Cycle Comovement

No. 116

No. 108

Jörn Kleinert, Julien Martin and Farid Toubal

Accounting for Real Exchange Rates Using
Micro-Data

No. 117

Mario J. Crucini and Anthony Landry

Central Bank Credibility and the Persistence
of Inflation and Inflation Expectations

No. 109

J. Scott Davis

Policy Regimes, Policy Shifts, and U.S.
Business Cycles

No. 118

Saroj Bhattarai, Jae Won Lee and Woong Yong
Park

Do Good Institutions Promote CounterCyclical Macroeconomic Policies?

No. 110

César Calderón, Roberto Duncan and Klaus
Schmidt-Hebbel

International Reserves and Gross Capital
Flows: Dynamics During Financial Stress

No. 119

Enrique Alberola, Aitor Erce and José Maria Serena Modelling Global Trade Flows: Results from a
GVAR Model

No. 111
The Perils of Aggregating Foreign Variables in
Panel Data Models

Michele Ca’ Zorzi, Alexander Chudik and Alistair
Dieppe

Matthieu Bussière, Alexander Chudik and Giulia
Sestieri

Globalization and Monetary Policy Institute 2012 Annual Report • FEDERAL RESERVE BANK OF DALLAS 45

No. 120
Global Banks, Financial Shocks and
International Business Cycles: Evidence
from an Estimated Model

No. 129
Price Equalization Does Not Imply Free Trade

Piyusha Mutreja, B. Ravikumar, Raymond
Riezman and Michael Sposi

Robert Kollmann

No. 121
In the Shadow of the United States: The
International Transmission Effect of Asset
Returns

No. 130
Market Structure and Exchange Rate
Pass-Through

Raphael A. Auer and Raphael S. Schoenle

Kuang-Liang Chang, Nan-Kuang Chen and
Charles Ka Yui Leung

No. 131

No. 122

Janet Koech and Mark A. Wynne

The Between Firm Effect with Multiproduct
Firms

Tuan Anh Luong

No. 123

Core Import Price Inflation in the United
States

No. 132
IKEA: Product, Pricing, and Pass-Through

Marianne Baxter and Anthony Landry

Global Slack as a Determinant of U.S.
Inflation

No. 133

Enrique Martínez-García and Mark A. Wynne

Javier Bianchi

No. 124
Inflation Dynamics: The Role of Public Debt
and Policy Regimes

Saroj Bhattarai, Jae Won Lee and Woong Yong
Park

No. 125
Quality Pricing-To-Market

Raphael A. Auer, Thomas Chaney and Philip Sauré

No. 126
Ultra Easy Monetary Policy and the Law of
Unintended Consequences

William R. White

No. 127
Selective Sovereign Defaults

Aitor Erce

No. 128
Does the IMF’s Official Support Affect
Sovereign Bonds Maturities?

Aitor Erce

Efficient Bailouts?

No. 134
The Effect of Commodity Price Shocks on
Underlying Inflation: The Role of Central
Bank Credibility

J. Scott Davis

46 Federal Reserve Bank of Dallas • Globalization and Monetary Policy Institute 2012 Annual Report

New Colleagues at the Institute
New Research Associates
Javier Bianchi

Aitor Erce

Césaire Meh

University of Wisconsin–Madison

Bank of Spain

Bank of Canada

Hafedh Bouakez

Pedro Gete

Simone Meier

HEC Montréal

Georgetown University

Swiss National Bank

Bo Chen

Yi Huang

Deokwoo Nam

Shanghai University of Finance and Economics

International Monetary Fund

City University of Hong Kong

Hongyi Chen

Charles Ka Yui Leung

Vincenzo Quadrini

Hong Kong Institute for Monetary Research

City University of Hong Kong

University of Southern California

Yin-Wong Cheung

Nan Li

Bent E. Sorensen

UC Santa Cruz/City University of Hong Kong

Ohio State University

University of Houston

Dudley Cooke

Shu Lin

Cédric Tille

University of Exeter Business School

Fudan University

Graduate Institute of International and
Development Studies, Geneva

Roberto Duncan

Tuan Anh Luong

Ohio University

Shanghai University of Finance and Economics

New Staff at the Institute
Michael Sposi
joined the Dallas
Fed in August 2012.
He has previously
served as a visiting scholar at the
St. Louis Fed. His
research explores
the role of international trade in explaining international prices,
as well as the links between international
trade and the process of economic development. He holds a PhD in economics from the
University of Iowa.

Valerie
Grossman has
been a research assistant in the Globalization and Monetary
Policy Institute since
July 2012. A native of
Dallas, she graduated
summa cum laude
from SMU in May 2012 with a BS in economics
and a BA in advertising, receiving both departments’ top academic achievement awards. While
attending SMU, she was also a research assistant
for Dr. Isaac Mbiti’s work on Kenyan remittances.

Globalization and Monetary Policy Institute 2012 Annual Report • FEDERAL RESERVE BANK OF DALLAS 47

Institute Staff, Advisory Board
and Senior Fellows
Institute Director
Mark A. Wynne
Staff Economists
Alexander Chudik
Scott Davis
Anthony Landry
Enrique Martínez-García
Michael Sposi
Jian Wang

Finn Kydland

Mario Crucini

Jeff Henley Professor of Economics,
University of California, Santa Barbara
Recipient, 2004 Nobel Memorial Prize in
Economic Sciences

Professor of Economics,
Vanderbilt University

Guillermo Ortiz
Former Governor, Banco de México

Advisory Board
John B. Taylor, Chairman
Mary and Robert Raymond Professor of
Economics, Stanford University

Charles R. Bean
Deputy Governor, Bank of England

Martin Feldstein
George F. Baker Professor of Economics,
Harvard University

Heng Swee Keat
Former Managing Director, Monetary Authority
of Singapore

Kenneth S. Rogoff
Thomas D. Cabot Professor of Public Policy,
Harvard University

Masaaki Shirakawa
Governor, Bank of Japan

William White
Former Head of the Monetary and Economic
Department, Bank for International Settlements

Senior Fellows
Marianne Baxter
Professor of Economics, Boston University

R. Glenn Hubbard

Michael Bordo

Dean and Russell L. Carson Professor of Finance
and Economics, Graduate School of Business,
Columbia University

Professor of Economics, Rutgers University

Otmar Issing
President, Center for Financial Studies (Germany)

Horst Köhler
Former President of the Federal Republic of
Germany

W. Michael Cox
Director of the O’Neil Center for Global Markets
and Freedom, Cox School of Business,
Southern Methodist University

Michael B. Devereux
Professor of Economics , University of
British Columbia

Charles Engel
Professor of Economics, University of
Wisconsin–Madison

Karen Lewis
Joseph and Ida Sondheim Professor in
International Economics and Finance,
University of Pennsylvania’s Wharton School

Francis E. Warnock
Paul M. Hammaker Professor of Business
Administration, Darden Graduate School
of Business, University of Virginia

48 Federal Reserve Bank of Dallas • Globalization and Monetary Policy Institute 2012 Annual Report