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FEDERAL RESERVE BANK OF DALLAS

Globalization and
Monetary Policy Institute

2014 ANNUAL REPORT

Contents
Letter from the President

Globalization: The Elephant in the Room
That Is No More

Understanding Trade, Exchange Rates and
International Capital Flows

Toward a Better Understanding of
Macroeconomic Interdependence

Summary of Activities 2014

Micro-Foundations of International Trade,
Global Imbalances and Implications on
Monetary Policy

The Political Economy of International Money:
Common Currencies, Currency Wars and
Exorbitant Privilege

The Federal Reserve’s Role in the Global Economy:
A Historical Perspective

Institute Working Papers Issued in 2014

Institute Staff, Advisory Board and
Senior Fellows

Research Associates

Published by the Federal Reserve Bank of Dallas, February 2015. 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 2014 Annual Report • FEDERAL RESERVE BANK OF DALLAS 1

Letter from the
President

hen I took office as president
of the Federal Reserve Bank of
Dallas in April 2005, I mandated
that the Research Department
make the study of globalization and its implications for monetary policy its top priority. Up to
that point, the department had a strong emphasis
on the study of Latin America, but I believed it
important for the Reserve Banks to look beyond
their immediate neighborhoods to think about
economic developments on a global scale. We
created the Globalization and Monetary Policy
Institute to leverage our local efforts in Dallas.
As I prepare to step down as president of the
Dallas Fed, I look back with great pride on all that
the institute has accomplished.
There is no simple answer to the question
of how globalization matters for U.S. monetary
policy. When I began speaking about this issue,
a lot of the emphasis was on the disinflationary
impact of the integration of large trading economies such as China into the global trading system.
We are now more confident that cheap imports
of manufactured goods from China did play an
important role in restraining headline inflation in
the advanced economies for some time. But we
also learned that the overall inflationary effect
of the rise of China and other emerging market
economies on inflation dynamics was more subtle
due to the voracious demands of these countries
for raw materials and commodities.
To some extent, the focus on the inflationary
consequences of globalization was misplaced. Far
more important—in light of subsequent developments—was the extraordinary growth of financial
globalization. Prior to the recent global financial

crisis, many worried about the global imbalances that were one manifestation of the growth
of financial globalization. Others argued that
imbalances were not an important concern, that
international financial flows reflected the optimizing decisions of individual investors that presumably knew a lot more about what they were doing
than did policymakers. Further, a consensus had
emerged in the academic and central banking
communities that inflation targeting sufficed to
ensure macroeconomic stability.
We now know that the consensus surrounding inflation targeting was mistaken or, at a minimum, incomplete. Cross-border capital flows are
not always benign, but rather have the potential to
fuel unsustainable asset price bubbles that create
challenges for central banks seeking to deliver on
their mandates. As I have noted on other occasions, the recent housing boom and bust in the
United States would have ended sooner and with
less dire consequences for the U.S. economy had it
not been for our ability to borrow large amounts of
money from foreigners.
Of course, while globalization has presented
challenges for policymakers around the world, it
has also brought enormous benefits to the citizens
of the U.S. and every other country. Globalization
has lifted hundreds of millions of people out of
poverty and has done more to boost global living
standards than any event since the Industrial
Revolution of the late 18th and early 19th centuries. The challenge for policymakers worldwide
will be to manage the process of globalization so
as to cement these gains and limit the destabilizing effects of greater global integration.
Major revolutions in economic theory are

usually prompted by real world developments.
The invention of macroeconomics as a field of
study in the 1930s was prompted by the perceived
inability of classical economics to account for the
prolonged periods of high unemployment that
many advanced economies experienced during
the Great Depression. The emergence of monetarism and the rational expectations revolution of the
1970s were likewise prompted by the inability of
the postwar neoclassical synthesis to explain the
simultaneous existence of high inflation and high
unemployment during the Great Inflation. It is my
belief that the Great Recession will likewise precipitate a major shift in the way economists think
about the macroeconomy, toward a paradigm
where finance and global linkages play a greater
role than they do now.
I am very proud of the achievements of our
Globalization and Monetary Policy Institute in
contributing to advancing our understanding of this
important phenomenon through the hundreds of
working papers that have been circulated through
its working paper series over the past seven years.
This year’s institute annual report contains essays
by three of the senior staff of the institute explaining how their individual research programs have
helped advance our understanding of globalization,
and I commend them to you highly.

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

2 FEDERAL RESERVE BANK OF DALLAS • Globalization and Monetary Policy Institute 2014 Annual Report

Globalization: The Elephant
in the Room That Is No More
By Enrique Martínez-García

Unlike what has
been conventionally
argued, the forces of
globalization appear
to be—if anything—a
headwind to
the conduct of
monetary policy
for the purpose of
macroeconomic
stabilization.

everal decades of increasing global
economic integration—or globalization—have left their mark. Whether
this structural shift has altered
the conduct of monetary policy or its ability to
promote economic stability over the business
cycle has long been debated.1 Woodford (2010),
among others, convincingly argued on theoretical
grounds that globalization does not necessarily
imply a weakening of the ability of national central
banks to influence domestic output and inflation.
However, the question of monetary policy effectiveness is only part of the story.
As Bernanke (2007) puts it, our current understanding is geared toward the view that “[a]t the
broadest level, globalization influences the conduct
of monetary policy through its powerful effects
on the economic and financial environment in
which monetary policy must operate.” Much of the
literature—including my own work—has in fact
focused on how globalization may have changed
the economic environment and, thus, altered the
trade-off between output and inflation volatility for
monetary policy. It is known that the business-cycle
volatility of the largest economies, including the
U.S., has shifted significantly during the post-World
War II period. The question, then, is to what extent
those changes reflect globalization?
This essay draws heavily on the analysis of
Martínez-García (2014b), which extensively reviews recent theory and the empirical evidence for
the post-WWII period (starting in 1960) to shed
light on the role of globalization. Based on data
for eight major advanced economies (U.S., U.K.,
Germany, France, Italy, Spain, Japan and Canada),
Martínez-García (2014b) shows a pattern of shifting business cycles partly linked to globalization.
While a review of all plausible explanations to account for changes in the business cycle is beyond

the scope of this review, the main takeaway is
that no single hypothesis—including globalization—can quantitatively explain the volatility shifts
observed since the 1960s.
Globalization, nonetheless, matters for
policymaking. To the extent that more open
markets have contributed to changes in businesscycle volatility, globalization has also played a
role in shifting the trade-offs of monetary policy
over time. Furthermore, unlike what has been
conventionally argued, the forces of globalization appear to be—if anything—a headwind to
the conduct of monetary policy for the purpose
of macroeconomic stabilization. They may have
even raised the costs of conducting monetary
policy. That is not to say that globalization should
be viewed negatively, but rather that its impact on
the relevant policy trade-offs must be recognized
when designing a successful monetary policy.
International Business Cycles:
What Has Changed and Why It Matters

Business-cycle volatility is often described
with the standard deviation that reflects how
spread out data are around the average. Over time,
how dispersed the data appear (the volatility) may
change, but so can the averages. Martínez-García’s
(2014b) estimates of volatility (conditional standard deviations) are based on the robust model
specification proposed by Stock and Watson
(2003a, b) to identify volatility shifts whenever
the central tendency (conditional mean) is also
changing.2 I reproduce those conditional standard
deviation estimates of quarterly real gross domestic product (GDP) growth in Chart 1 and of quarterly inflation—derived from the GDP deflator—in
Chart 2 to illustrate changes in business-cycle
volatility in the U.S. and the other seven major
advanced economies.

Globalization and Monetary Policy Institute 2014 Annual Report • FEDERAL RESERVE BANK OF DALLAS 3

Bernanke (2004) notes that “[o]ne of the
most striking features of the economic landscape
over the past twenty years or so has been a substantial decline in macroeconomic volatility.” The
empirical evidence presented in Chart 1 shows a
widespread decline in output volatility since the
early 1970s. For the median advanced economy,
the 1960s was a decade of rising output growth
volatility, followed by a secular (and gradual)
decline starting in the early 1970s. The downward
trend stopped just before the 2008 global recession. That period of declining output volatility is
known as the Great Moderation.
The Great Moderation in the U.S.—unlike for
the median advanced economy—is characterized
by a sharp decline in the conditional standard
deviation of GDP growth around 1984 (Kim and
Nelson 1999; McConnell and Pérez-Quirós 2000;
and Stock and Watson 2003a, b). The U.S. also
experienced a marked phase of elevated volatility
during the 1970s coinciding with the collapse
of the post-WWII Bretton Woods international
monetary system and the high inflation and low
growth (stagflation) that followed.
Inflation volatility rose in the late 1960s and
early 1970s as the strains of the Bretton Woods
system became more apparent and its collapse
all but inevitable (see Chart 2). Interestingly, the
data show a dramatic and widespread decline in
inflation volatility between the mid-1970s and the
mid-1990s, followed by an equally sizable—but
uneven—rise afterward. For the median advanced
economy, inflation volatility surpassed its previous historical peak in the mid-2000s. European
countries in the years leading up to the adoption
of the euro were most affected by this rise in inflation volatility. By comparison, inflation volatility
remained fairly low in the U.S.
Output and inflation volatility breaks also occurred as other features of the international business cycle of the post-WWII period changed—notably, the cyclicality and cross-country correlation
of inflation and the price level and the forecastability of growth and inflation, as discussed by
Martínez-García (2014b). Interestingly, the most
significant changes in business-cycle features for
real variables—other than the secular decline in
output volatility—appear at the onset of the 2008
global recession.

Chart 1
Real GDP Growth Volatility Declines
Scaled percentage
2.5

1.5

G-8 median real GDP growth (volatility)
U.S. real GDP growth (volatility)
Interquartile range

0
’62 ’65 ’68 ’71 ’74 ’77 ’80 ’83 ’86 ’89 ’92 ’95 ’98 ’01 ’04 ’07 ’10 ’13

NOTE: Median and interquartile range includes U.S., U.K., Canada, France, Germany, Japan,
Spain and Italy. The median measures the central tendency, while the interquartile range
reflects the dispersion around the median of the countries in the sample. Volatility refers to the
estimated time-varying standard deviation of real GDP growth.
SOURCES: Organization for Economic Cooperation and Development; author’s calculations.

Chart 2
Inflation Volatility in G-8, U.S. Diverge
(GDP deflator)
Scaled percentage
.9
.8
.7
.6
.5
.4
.3
.2
.1

G-8 median inflation (volatility)
U.S. inflation (volatility)
Interquartile range

0
’62 ’65 ’68 ’71 ’74 ’77 ’80 ’83 ’86 ’89 ’92 ’95 ’98 ’01 ’04 ’07 ’10 ’13

NOTES: Median and interquartile range includes U.S., U.K., Canada, France, Germany, Japan,
Spain and Italy. The median measures the central tendency, while the interquartile range
reflects the dispersion around the median of the countries in the sample. Volatility refers to the
estimated time-varying standard deviation of inflation calculated with the GDP deflator.
SOURCES: Organization for Economic Cooperation and Development; author’s calculations.

4 FEDERAL RESERVE BANK OF DALLAS • Globalization and Monetary Policy Institute 2014 Annual Report

Martínez-García (2014b) finds no evidence
of an increase in output growth synchronization
for the period leading up to the 2008 global recession, suggesting weak empirical support for the
hypothesis that globalization has altered international business-cycle synchronization. Consumption-smoothing motives, in theory, should imply a
high correlation of consumption across countries
regardless of the cross-country output correlation—at least if complete international risk-sharing
were possible. Martínez-García (2014b) also documents that at least since the 1960s, cross-country
output correlations tend to be consistently higher
than cross-country consumption correlations.
Backus et al. (1992) call this observation “the most
striking discrepancy ... between theory and data.”
The international literature has retained the
idea that resolving this puzzle does not mean
abandoning the view that asset markets are
complete to the extent that they allow efficient
risk-sharing across countries. Obstfeld and Rogoff
(2001) suggest that “a (significant but plausible)
level of international trade costs in goods markets”
suffices to account for the comovement observed
in the data.
Trade costs refer to transport costs and tariffs
but may also include nontariff barriers and other
structural distortions that impede intra-temporal
consumption smoothing through trade. What
matters for bilateral trade, however, are not the
trade barriers between any two countries by
themselves but how they relate to the barriers
with respect to all their other trading partners.
Martínez-García and Martínez-García (2014)
show empirically that factors such as language,
legal traditions, culture and historical ties—which
generally change very slowly—can have major
effects as relative barriers to trade. They find that
the effect of nontariff trade barriers has remained
largely invariant since the Great Moderation in
spite of greater economic integration.
A number of other explanations have also
been proposed—especially in the presence
of distortions in goods and capital markets.
Martínez-García and Søndergaard (2009) show,
in particular, how comovement of consumption
across countries depends crucially on the degree
of international risk-sharing that can be attained
and supported by trade.3 Hence, from the perspec-

tive of theory, globalization—and financial globalization in particular—has an ambiguous effect
on the comovement of output and consumption.
While the debate is far from settled, globalization
remains an important part of the discussion in
regard to these business-cycle features.
How the Economic Environment
Changed with Globalization

Much of the debate about the role of
globalization has revolved around the perceived
flattening of the short-run Phillips curve.4 In fact,
inﬂation seems to have become less responsive
to ﬂuctuations in output relative to its potential
over time.5 This has been documented for the U.S.
by Roberts (2006), among others, who identified
the flattening of the Phillips curve around 1984—
at the start of the Great Moderation in the U.S.
Borio and Filardo (2007) indicate that a similar
phenomenon can be detected in a number of
other countries. Their findings suggest a decline
in the sensitivity of inflation to the domestic
output gap—deviations of domestic output from
its potential—among Organization for Economic
Cooperation and Development countries, but a
greater role for global slack—deviations of global
output from its potential.
As in Martínez-García (2014b), a standard
Phillips curve-based model can be estimated that
relates current inflation to four past data points, or
lags, and the previous quarter’s domestic output
gap (measured with Hodrick–Prescott [1997]
filtered domestic real GDP). The coefficient on
the domestic output gap in this model indicates
the sensitivity of inflation to changes in domestic
resource utilization, or slack. Chart 3, taken from
Martínez-García (2014b), illustrates estimates
of the coefficient on the domestic output gap.6
Over time, the estimates have indeed declined,
indicating decreased sensitivity of inflation to the
domestic output gap.
The flattening has been more gradual in
the U.S. than for the median advanced economy.
The estimated coefficient increased temporarily
during the 1980s. The major break occurred in
the early 1990s when the estimate dropped below
historical precedent. In the U.S., the coefficient has
remained at approximately half of its pre-1990
peak. For the median advanced economy, the co-

Globalization and Monetary Policy Institute 2014 Annual Report • FEDERAL RESERVE BANK OF DALLAS 5

efficient stayed below the U.S. value until catching
up in the early 2000s. Interestingly, the estimates
seem little changed in the aftermath of the 2008
global recession.
A number of empirical studies have challenged the notion that this evidence on the
flattening of the Phillips curve is in fact related to
globalization—see the arguments of Ball (2006)
and Ihrig et al. (2007), which at least partially
refute those of Borio and Filardo (2007). MartínezGarcía and Wynne (2010), however, suggest that
the mixed empirical evidence to a degree reflects
data limitations and mismeasurement.
Martínez-García and Wynne’s (2010) arguments also fit into a much larger debate about
whether the short-run Phillips curve has become
flatter or, in turn, potential has shifted over time
(see the views of Borio et al. 2013 on the role of
financial factors in measuring the output gap).
Martínez-García and Wynne’s (2010) key insight
is that changes in the slope of the Phillips curve
cannot be estimated independently of the assumptions made about output potential (which is
inherently unobservable). If potential output and
thus the output gap are misspecified, one cannot
conclude much about a possible structural change
in the slope of the Phillips curve or simply negate
the role of globalization from this evidence.
A more structural approach seems warranted, but Martínez-García, Vilán and Wynne (2012)
and Martínez-García and Wynne (2014) show in
controlled experiments with simulated data that
there are significant challenges to identification
and model selection that limit the practical usefulness of standard econometric techniques to reveal
empirically the exact role of greater economic
integration. In any event, even within a structural
framework, estimating slack and the sensitivity of
inflation to slack still requires that we take a stand
on the specification of the unobservable potential
output.
Another approach to investigate the plausibility of the theory—on the role of globalization—
consists of identifying key empirical predictions
that can help distinguish between competing
explanations. Kabukçuoglu and Martínez-García
(2014) show that Phillips curve-based forecasting
models relying on the domestic output gap appear
to have lost ground over time against simpler sta-

tistical models that aren’t dependent on measures
of slack—especially during the period of declining
inflation volatility until the mid-1990s, as seen in
Chart 2.7
More encouragingly, Kabukçuoglu and
Martínez-García (2014) also suggest a number of
indirect measures of global slack consistent with
the open-economy Phillips curve (Clarida, Galí
and Gertler 2002; Martínez-García and Wynne
2010). These are generally better measured than
global output and more readily available and,
in theory, should capture the relevant external
economic forces. According to Kabukçuoglu and
Martínez-García (2014), the most useful variables
to restore—at least to some extent—the predictive ability of Phillips curve-based forecasts for
inflation include terms of trade and global money
growth.
The evidence of Kabukçuoglu and MartínezGarcía (2014) is consistent with the view that
globalization has altered the trade-off implied by
standard closed-economy Phillips curves, linking
domestic inflation to global (rather than local)
slack. It also appears consistent with a flattening

of the empirical Phillips curve as global forces
come to dominate domestic ones. Thus, the global
slack hypothesis articulated by Martínez-García
and Wynne (2010, 2013) appears to offer an
empirically plausible way to characterize inflation
without abandoning altogether the idea of a shortrun trade-off between inflation and real economic
activity embedded in the Phillips curve.
It is also important to further consider how
changes in inflation and the Phillips curve tradeoff with real economic activity can in turn be
linked to globalization. There are in fact a number
of theoretical explanations for why structural
changes in the slope of the Phillips curve through
globalization may not necessarily linearly correlate with measures of greater openness and
for why domestic inflation would be affected by
global rather than local factors:
• Martínez-García and Wynne (2010)
show that stronger bilateral ties through trade
increase the direct contribution of import prices
to measured domestic inflation. Greater openness
is consistent with a decline in the Phillips curve
slope on the domestic output gap and an increase

Chart 3
Estimated Coefficient on Domestic Output Gap Declines
(Sensitivity of inflation to domestic output gap decreases)*
Estimated coefficient
.7
.6

G-8 median coefficient
U.S. coefficient
Interquartile range

.5
.4
.3
.2
.1
0
–.1

’76 ’78 ’80 ’82' ’84 ’86 ’88 ’90 ’92 ’94 ’96 ’98 ’00 ’02 ’04 ’06 ’08 ’10 ’12 ’14

*Reduced-form Phillips curve model.
NOTES: Median and interquartile range includes U.S., U.K., Canada, France, Germany, Japan,
Spain and Italy. Output gaps calculated with the Hodrick–Prescott (1997) filter on real GDP. The
median measures the central tendency, while the interquartile range reflects the dispersion
around the median of the countries in the sample. The coefficient estimates reported are based
on a rolling window of 15 years of quarterly data.
SOURCES: Organization for Economic Cooperation and Development; author’s calculations.

6 FEDERAL RESERVE BANK OF DALLAS • Globalization and Monetary Policy Institute 2014 Annual Report

in the slope on the foreign gap. However, a more
complex, nonlinear relationship may arise when
countries differ in how open they are and how
much more open they have become than the
rest. This may explain at least qualitatively why
measures of openness do not always appear to
linearly correlate with the estimates of the slope of
the Phillips curve.
• Imported goods may also affect inflation
indirectly through their impact on the marginal
costs faced by domestic producers and on their
pricing power. Arguably, greater openness to
trade and the resulting increase in competitive
pressures may lead to reduced markups. These
competitive pressures can also enhance productivity growth, as less productive firms get pushed
out of the market, facilitating the goal of attaining
lower inflation.
• The build-up of domestic slack makes it
more difficult for firms to increase prices and
for workers to negotiate higher wages, which
keeps inflation at bay. However, in an increas-

ingly integrated world economy, reduced global
slack can increase domestic inflation even when
domestic slack remains invariant (a theoretical
point argued by Martínez-García and Wynne
2010, 2013). As the economy becomes more open,
it tends to matter more for domestic inflation that
domestic firms can charge more for their goods in
the domestic market when they face increases in
world demand.
For all these reasons, it would appear
too much of a stretch to refute the global slack
hypothesis on the basis of the existing evidence
(as can be seen in the arguments of Bernanke
2007 and Martínez-García and Wynne 2010, 2013,
among others). A significant role for globalization
is both theoretically plausible and not empirically
inconsistent with nonlinear shifts in the slope
of the Phillips curve, even if the question of how
quantitatively important it ultimately is remains
open to debate.
Globalization and Monetary Policy:
Lessons Learned

Chart 4
Monetary Policy and Variability (Volatility) Trade-Off
Ratio*
10
1960–83

1984–2007

2008–13

7
6
5
4
3
2
1
0

.6
.8
Standard deviation of inflation

1.2

1.4

*Standard deviation of output/standard deviation of inflation.
NOTES: Includes U.S., U.K., Canada, France, Germany, Japan, Spain and Italy. Volatility is
measured with estimates of the conditional standard deviations, that is the squared root of the
variance. The curved black line is the simulated policy frontier under a policy framework based
on the Taylor (1993) rule. This policy frontier is derived from simulations of the open-economy
model of Martínez-García and Wynne (2010, 2013) for the period 1984–2007.
SOURCES: Organization for Economic Cooperation and Development; author’s calculations.

Following Martínez-García (2014b), I
consider the open-economy Phillips curve of
Martínez-García and Wynne (2010) to be a valid
framework to investigate the trade-off between
inflation and real economic activity. I assume the
economic structure and the distribution of shocks
to be invariant. Under these baseline assumptions,
New Keynesian economic models—which have
featured prominently in policy analysis over the
past two decades—imply that, over the long run,
monetary policy makers operating under a Taylor
rule framework (Taylor 1993) can reduce the volatility of inflation only by allowing greater relative
volatility in output, and vice versa.
In other words, theory suggests a policy
trade-off between the volatility in inflation and
the ratio of output volatility over inflation volatility—similar to the well-known Taylor curve (for
example, Taylor 1979, 2014). Chart 4, taken from
Martínez-García (2014b), illustrates this variability trade-off with a model simulation based
on Martínez-García and Wynne (2010, 2013). The
model simulation aims to represent the tradeoffs resulting from Taylor rules with different
responses to inflation based on the experience of
the major advanced economies during the Great

Globalization and Monetary Policy Institute 2014 Annual Report • FEDERAL RESERVE BANK OF DALLAS 7

Moderation (between 1984 and 2007).
In a purely mechanical sense, output fluctuations are expected to increase (output becoming
more volatile) as the Phillips curve flattens if the
fluctuations of inflation and output potential
remain invariant. Hence, it is no surprise that
Martínez-García (2014b) finds that the variability
trade-offs between output and inflation faced
by policymakers—if anything—may have shifted
away from the origin as the Phillips curve leveled
off down and the world economy became more
integrated during the Great Moderation.8
Martínez-García (2014b) indicates that such
a shift in the attainable policy trade-offs frontier
under a Taylor rule can occur under the assumption of coordinated monetary policy. When de
facto unilateral changes in monetary policy are
considered, globalization appears to contribute
also to a further widening of the distance in the
policy frontier across countries and to greater
divergence in policy performance.
While much more research is needed to fully
understand the different aspects of globalization
and how they interact with monetary policy, this
analysis shows that the degree to which economies have become intertwined cannot be ignored
in policymaking. Policymakers should be mindful
that globalization has the potential to alter the
volatility frontier that can be reached and make
domestic stabilization policies increasingly dependent on the policies of other countries.
Conclusion

Ongoing global economic integration is a
transformative phenomenon that has shaped the
world economy for decades and will likely continue to do so. Globalization has not negated central
banks’ ability to influence domestic conditions.
Nonetheless, globalization has had, and potentially will continue to have, an impact on inflation,
the trade-off between inflation and real economic
activity confronting policymakers, and the nature
of the monetary transmission mechanism as suggested by the workhorse open-economy models
of Clarida et al. (2002) and Martínez-García and
Wynne (2010).
As Federal Reserve Bank of Dallas President
Richard Fisher (2006) noted, “The literature on
globalization is large. The literature on mon-

etary policy is vast. But literature examining the
combination of the two is surprisingly small.”
Effective monetary policymaking requires more
than ever before in the post-WWII period taking
into account a diverse set of global factors, some
of them not yet fully understood or even clearly
identified. Scholars and policymakers must continue to further our understanding of the effects of
globalization in general and on the conduct and
international transmission of monetary policy in
particular.
Notes
This document has greatly benefited from the research
assistance of Valerie Grossman and the contributions of
Bradley Graves, and from my ongoing work with Ayse
Kabukçuoglu and María Teresa Martínez-García. I dedicate
this essay to the memory of my father, Valentín Martínez
Mira, whose inspiration and unwavering support over the
years made it all possible.
1
See, for example, Fisher (2005, 2006), International Monetary Fund (2006), Rogoff (2006), Yellen (2006), Bernanke
(2007), Mishkin (2007), Weber (2007), González-Páramo
(2008) and Papademos (2010).
2
Shifts in the conditional mean have occurred and can
presumably be related to globalization as well. This essay
does not further pursue the issue.
3
Other potential explanations to reconcile theory with data
on consumption and output cross-correlations include: a)
Frictions impeding the accumulation of capital (or affecting
the relative price of investment), which can influence the
economy’s ability to absorb domestic and external shocks
(see, for example, Martínez-García 2011 and MartínezGarcía and Søndergaard 2013); b) Incomplete asset markets
in which there are not enough assets to attain perfect risksharing (Martínez-García 2011); c) Asymmetric information
in the formation of expectations affecting the consumption–investment decision margin—particularly, with regard
to foreign shocks (Martínez-García 2010)—or the pricing
behavior of firms; d) The amplification/dampening effects
of financial frictions on innovations to the mean or the
volatility of the shocks (Martínez-García 2014a; Balke,
Martínez-García and Zeng 2014).
4
Phillips (1958) is credited with identifying the empirical
inverse relationship between nominal wage changes and
unemployment that bears his name and is regarded as the
conceptual precursor of the New Keynesian Phillips curve
used in this essay’s arguments (Martínez-García and Wynne
2010). However, the idea behind the Phillips curve has a
much earlier precedent in Fisher (1926) that should be duly
noted.
5
Output potential in this sense refers to the counterfactual
level of output that could be attained given the same realization of the shocks to the economy if distortions preventing the full and instantaneous adjustment of prices could be

8 FEDERAL RESERVE BANK OF DALLAS • Globalization and Monetary Policy Institute 2014 Annual Report

removed. The output gap, or slack of the economy, tracks
the fluctuations in output around its potential. It measures
the extent to which resources are underutilized/overutilized
in production, and in the context of the New Keynesian
Phillips curve, it can signal inflationary pressures.
6
Chart 3 is based on a rolling window regression of the
Phillips curve model for inflation based on four lags of
itself and the previous quarter domestic output gap using
15 years of quarterly data. A rolling window regression
involves running multiple regressions of a fixed sample size
with a different window of observation at a time. In this
case, the first regression is done on an initial window with
the first 60 quarterly observations in the data. The second
regression is performed with another 60 observations,
starting from the second to the 61st observation. Similarly,
the third window goes from the third to the 62nd observation, and so on. Using rolling window regressions produces
varying estimates of the coefficient on the domestic output
gap over time instead of a constant estimate for the entire
period. In that sense, it reveals the changing properties of
the regression—providing evidence of the flattening of the
Phillips curve.
Atkeson and Ohanian (2001), for instance, also show that
backward-looking Phillips curve forecasts of U.S. inflation
based on output gaps are often found to be inferior against
a naïve forecast.
8
The sacrifice ratio measures the reduction in output
required for a given reduction in inflation. A flattening of
the Phillips curve, therefore, may imply that the sacrifice
ratio may have changed as well. This essay does not further
explore this issue or its connection to globalization.
7

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10 FEDERAL RESERVE BANK OF DALLAS • Globalization and Monetary Policy Institute 2014 Annual Report

Understanding Trade, Exchange Rates and
International Capital Flows
By Jian Wang

Global trade
collapsed following
the financial crisis
in 2008–09. Imports
and exports plunged
in major trade
countries, and global
trade suffered the
biggest contraction
since World War II.

he U.S. has embraced rapid globalization since the 1970s, with
the trade share of gross domestic
product (GDP) increasing from less
than 6 percent in 1970 to over 15 percent in 2013.
Financial integration is even more phenomenal:
The GDP share of foreign assets invested in the
U.S. increased more than tenfold from around 10
percent in 1970 to over 150 percent in 2013. U.S.
financial assets invested abroad grew at a similar
pace over the period.
The rapid real and financial globalization in
the past 30 years poses many challenges to policymakers in the U.S. and around the globe. When
making decisions at home, they can no longer
ignore changes abroad. Policymakers must better
understand the interaction among domestic and
foreign economies as they seek to maximize their
nation’s welfare.
My research has primarily focused on understanding the interactions of economies through
international trade and financial markets. Globalization has made countries more integrated than
ever, and countries are no longer insulated from
shocks that originate from abroad. Policymaking
requires an understanding of how real and monetary changes are transmitted across countries
through international trade and financial markets.

underestimate foreign country influence through
international trade on a domestic economy and
may provide misleading policy suggestions.
Why is international trade more volatile than
GDP in the data? Examining the properties of
traded goods across countries helps answer the
question. Most international trade for Organization for Economic Cooperation and Development
(OECD) countries involves durable goods, which
include durable consumption goods (such as
automobiles and personal computers) and capital
investment (such as machinery). Durable goods
purchases fluctuate more over business cycles
than nondurable goods. Families can postpone
replacing automobiles during a downturn more
easily than they can defer nondurable purchases
of food and gasoline. Because a large share of
GDP is nondurable goods and international trade
is mainly in durable goods, international trade
volume varies substantially more than GDP in the
data. We find that including durable goods trade in
an otherwise standard model, which doesn’t distinguish between durable and nondurable goods,
can broadly improve the model’s ability to match
trade sector data.
Global trade collapsed following the financial
crisis in 2008–09. Imports and exports plunged in
major trade countries, and global trade suffered
the biggest contraction since World War II. Various
International Trade and Exchange Rate
policies have been proposed in response to this
Pass-Through
decline. Based on research with Charles Engel, I
Engel and Wang (2011) found that standard
discussed the collapse of global trade in a Federal
open-economy models significantly understate the Reserve Bank of Dallas Economic Letter (Wang
importance of trade in economic fluctuations. Inter- 2010), which argues that the drop in international
national trade growth varies substantially more
trade was generally consistent with cyclical trade
than a nation’s total output growth over time, data
movements over the past 35 years. Empirical findings and a theoretical model in Engel and Wang
show. For instance, imports and exports are about
(2011) predict a large drop in the volume of trade
three times more volatile than GDP in the U.S. and
when markets experience a steep recession, espein most other countries, but they are less volatile
than GDP in standard open-economy models used cially if a prolonged downturn is expected. Several
to investigate the spillovers of shocks originating in subsequent studies confirm that the collapse of
global trade in the recent financial crisis was mainone country. These standard models substantially

Globalization and Monetary Policy Institute 2014 Annual Report • FEDERAL RESERVE BANK OF DALLAS 11

ly attributable to a collapse of worldwide demand
for durable goods (Chart 1), though other factors,
such as trade finance, may have played a role.
The exchange rate is a focal point of international economic activities. Exchange rate fluctuations alter the relative prices of goods and services
between countries and, thus, substantially impact
international trade.
An important channel through which the
exchange rate affects the real economy is aggregate price levels. The extent that exchange rate
changes are passed through to prices is referred
to as exchange rate pass-through (ERPT). Import
price ERPT declined sharply after the 1990s (see
Marazzi and Sheets 2007 for an example involving the U.S.). An and Wang (2012) and Mumtaz,
Oomen and Wang (2011) document that greater
economic stability after the 1980s—especially
involving monetary policy and inflation—contributed to reduced ERPT.
The findings suggest that ERPT decline is
related to more disciplined monetary policy after
the 1980s. Several factors may contribute to this
during such a stable monetary regime. Shambaugh
(2008) documents that ERPT is greater for nominal
shocks (for example, monetary policy shocks) than
for real shocks (for example, demand shocks). An
economy experiences fewer nominal shocks in a
regime with more stable monetary policy and inflation, and thus its ERPT is lower. The research shows
that low ERPT is not independent of monetary
policy. Therefore, it is misleading to argue that central banks can afford looser policy when inflation is
less responsive to exchange rate movements.
Another problem found in previous studies of ERPT is that aggregate price indexes may
underestimate the impact of exchange rates on
U.S. import prices. In goods-level data underlying
U.S. trade price indexes, Nakamura and Steinsson
(2012) document that 40 percent of products are
replaced without a single price change. They argue
that price adjustments for these goods are through
product replacement rather than regular price
changes: Firms replace existing products with
new models and designs at a new price rather
than changing current-item prices. Standard price
indexes that focus on price changes for identical
products cannot capture this type of adjustment
and underestimate the extent of price changes in

Chart 1
Real Demand for Durable Goods Declines Globally
Percent, quarter/quarter, annualized
5

U.S.

U.K.

Canada

Japan

–5

–10

–15

–20
2008:Q3

2008:Q4

2009:Q1

–25

SOURCES: Bureau of Economic Analysis; author’s calculations.

the economy.
Kim et al. (2013) investigate the productreplacement bias involving trade between the U.S.
and China and find that renminbi appreciation
substantially affects prices of U.S. imports from
China after taking into account price changes
through product replacement. Following China’s
abandonment of its hard-currency peg to the U.S.
dollar in June 2005, the renminbi appreciated more
than 25 percent by September 2014. However, only
a very small fraction of the Chinese currency gain
was passed on to U.S. import prices when ERPT
was estimated from aggregate price indexes. For
instance, Auer (2012) finds that ERPT of renminbi
appreciation from 2005 to 2008 into the U.S. import
price index was only around 20 percent.
Why didn’t Chinese exporters pass along
production cost increases following renminbi
appreciation, at least in the long run? One reason
could be producers’ voluntary reduction of profit
margin, which would help them maintain market
share. However, China’s exports to the U.S. are
mainly from labor-intensive industries, and it is
unlikely that Chinese exporters have a large profit
margin with which to absorb currency appreciation. A large share of imported inputs is another
potential reason for the low ERPT observed in
the data (see Amiti, Itskhoki and Konings 2014).
China imported many of its inputs from other

countries, and the prices of imported materials decreased when the renminbi appreciated, imposing
downward pressure on China’s export prices to the
U.S. However, this explanation conflicts with the
fact that the Chinese currency did not appreciate
much against countries providing a major source
of inputs—such as Japan and South Korea—while
it gained strongly against the U.S. dollar.
Kim et al. (2013) find that Chinese exports
did not absorb as much renminbi appreciation as
the aggregate import price index suggested. The
authors found that for a large fraction of U.S. imported goods from China, prices never changed.
Less than 50 percent of renminbi appreciation is
passed through to U.S. import prices from China
if these “no-price-change” goods are included in
the estimation of ERPT. Pass-through increases
to about 100 percent if goods with at least one
price change are included. In other words, ERPT is
much higher if goods that change prices through
product replacement are excluded, suggesting that
the conventional estimation of ERPT based on
aggregate price indexes underestimates the effect
of renminbi appreciation on U.S. import prices.
Exchange Rate Determination and
Business Cycles

Besides international trade, the exchange
rate plays an important role in international

12 FEDERAL RESERVE BANK OF DALLAS • Globalization and Monetary Policy Institute 2014 Annual Report

financial markets. The foreign exchange market
is the largest and most liquid financial market in
the world. Its average daily turnover exceeds $5
trillion, according to a 2013 survey by the Bank
for International Settlements. Currency trading is
important for individuals, firms and governments
that buy foreign goods and services, invest abroad
and seek profit or protection through speculation.
Despite the significance of exchange rates in
economic activity, researchers and policymakers
still debate the factors driving their fluctuation
and whether the central banks should consider
exchange rate movements when conducting
monetary policy.
Wang (2011) finds that the effect of including exchange rate stabilization in the Taylor rule
depends on several key factors (the rule theorizes
that an appropriate policy rate is based on an
economy’s performance relative to its capacity, the
output gap and the rate of inflation). Those factors
include the source of exchange rate fluctuation, the central bank’s stance on inflation and a
country’s trade openness. If the central bank takes
a strong stance on inflation, exchange rate stabilization can improve welfare by fine-tuning interest
rates to alleviate international price distortions

Chart 2
Inflation Lower in Countries Not Trying Exchange Rate Stabilization
Percent average monthly year/year inflation, March 2009–Dec. 2010
14
Russia

12
10

India

Tren
d

Turkey

6
Mexico

4
China

2
0

exclu

ding

Chin

South Africa

a
Brazil

Indonesia
Korea

10
20
30
40
50
60
Percent change in currency vs. U.S. dollar, March 2009–Dec. 2010

NOTE: The greater the percent change in currency vs. the U.S. dollar, the less likely the country’s central bank attempted to stabilize the exchange rate.
SOURCES: National statistics offices of each country; Haver Analytics; Wall Street Journal;
author’s calculations.

caused by noisy exchange rate movements and
sticky prices. Admittedly, welfare improvement
from exchange rate stabilization is small in the
model, especially if a country’s consumption is biased toward home-produced goods and services,
such as in the U.S.
For countries that do not appropriately anchor inflation, stabilizing the exchange rate through
monetary policy will substantially increase macro
instability and reduce overall welfare. In this case,
when a central bank attempts to alter interest rates
in response to exchange rate changes, it will tend to
amplify the negative effect of exchange rate noise
by destabilizing the inflation rate.
Following the 2008 financial crisis, the Federal Reserve instituted several rounds of quantitative
easing (QE) to stabilize the financial markets and
aid U.S. economic recovery. QE policy in the U.S.
inevitably spilled over to other countries through
exchange rates and interest rates. Wang (2011)
suggests that the central banks in other countries
should continue to focus on inflation stabilization and let exchange rate swings mostly run their
course. Unfortunately, policymakers, particularly
those in emerging markets, could not restrain
themselves from loosening monetary policy to
stabilize their currency’s value. As my model predicted, countries focusing more on exchange rate
stabilization during this period suffered higher
inflation and less-stable domestic macroeconomic
conditions (Chart 2).
This paper assumes that the exchange rate
was mainly driven by noise in financial markets.
Although this is a useful way for theoretical models to match exchange rate behavior in the data, it
remains highly debatable whether exchange rates
are determined by economic fundamentals or by
noise unrelated to economic fundamentals. Therefore, understanding the factors driving exchange
rate movements remains an important research
topic.
In a seminal paper, Meese and Rogoff (1983)
find that economic fundamentals—such as money
supply, balance of trade and national income—
are of little use when forecasting out-of-sample
exchange rates. This casts doubt on fundamentalbased exchange rate models. Various combinations of economic variables and econometric
methods have been used in attempts to over-

Globalization and Monetary Policy Institute 2014 Annual Report • FEDERAL RESERVE BANK OF DALLAS 13

turn Meese and Rogoff’s finding. Despite some
progress on this front, the ability of economic
fundamentals to forecast exchange rates remains
fragile in most empirical studies, especially at
short horizons.
Wang and Wu (2012) take a different approach to address the issue. Instead of estimating
the levels of exchange rates in the future, this
study provides an interval in which the exchange
rate may reside with a certain probability, given
predictors available at the time of the forecast.
The authors find that economic fundamentals are
useful in narrowing forecast intervals for exchange
rates, though they are not useful in predicting the
future average level.
Engel and West (2005) argue that current
economic fundamentals cannot forecast exchange
rates because exchange rates, like other asset
prices, are determined by expectations of future
economic fundamentals rather than the current
reality. Engel, Wang and Wu (2010) reconcile the
Engel–West theorem with empirical findings that
economic fundamentals better forecast exchange
rates at longer horizons.
From these studies, we learn that exchange
rates are related to expectations regarding
economic fundamentals rather than to financial
market noise. However, it remains unclear which
fundamentals play an important role in driving
exchange rates and whether expectations are followed by actual economic fundamental changes.
Answers to these questions provide guidance
for exchange rate modeling that can be used to
analyze international macroeconomic issues.
Nam and Wang (forthcoming) investigate
the role that expectations of future productivity
play in driving the U.S. exchange rate. The study
was inspired by empirical findings that changes
in expectations regarding future productivity,
measured by total factor productivity (TFP), account for a large fraction of U.S. business cycles.
Beaudry and Portier (2006) document that a
shock resembling favorable news about future
productivity explains more than half of businesscycle fluctuations of U.S. consumption and labor
input. Beaudry, Nam and Wang (2011) extend
this finding to models with more macroeconomic
variables, using alternative econometric methods
to identify the shock. They find that bouts of op-

timism and pessimism drive many U.S. business
cycles and that increasing optimism is followed by
subsequent TFP increases, suggesting a close link
between optimism and economic fundamentals.
Two scenarios are consistent with these
empirical findings. First, bouts of optimism reflect
advance information that agents have about future
TFP. In response to good news about future productivity, households increase current consumption and firms raise investment, though current
TFP remains constant. In another scenario, agents’
exogenous mood swings may cause an economic
boom and subsequent productivity increase.
Households and firms become optimistic about
the future for some unknown reasons, resulting in
immediate increases in consumption and investment. The economic boom today can increase
future productivity through different channels
such as promoting firms’ research and development and/or relaxing the financial constraints of
small but more productive firms.
Although these empirical findings show the
importance of optimism shocks in driving U.S.
business cycles, they cannot separate the above
two scenarios as underlying mechanisms. It is
important to investigate the empirical relevance
of these two competing views because they carry
totally different policy implications. If optimism
shocks reflect advance news about future productivity, there is no need to have policies designed to
stabilize such expectation-driven business cycles
because the optimism-driven booms are already
the optimal behavior of households and firms.
However, if economic booms and busts are driven
by exogenous bouts of optimism, the economic
outcome may be suboptimal and policymakers may want to fight excessive business-cycle
fluctuations if they can correctly identify excessive
optimism/pessimism.
Nam and Wang (forthcoming) extend the
study on optimism-driven business cycles to
multicountry settings and examine how expected
changes in productivity affect exchange rate
fluctuations and international trade. Previous
studies in the literature focus on surprise changes
in productivity that drive such fluctuations. These
empirical and theoretical studies usually underestimate the importance of productivity changes on
exchange rate movements and international spill-

overs of technology changes. For instance, previous empirical studies usually find that productivity
changes explain only a small fraction (10 percent
or less) of exchange rate fluctuations during business cycles (for example, Juvenal 2011). However,
Nam and Wang (forthcoming) document that after taking into account both surprise changes and
expected future changes, productivity can explain
over a third of U.S. exchange rate fluctuations.
Exchange rates are more volatile than economic fundamentals—such as total output—and
standard theoretical models fail to replicate this
feature in the data. The empirical findings suggest that the inclusion of expected productivity
change may help the standard model better reflect
the data by more closely matching asset prices
(such as exchange rate behaviors). Matsumoto
et al. (2011) show that, under certain conditions,
incorporating news about future productivity
and monetary policy helps standard theoretical
models match stock price volatility.
These empirical studies point out challenges
for future theoretical modeling of exchange rates.
Nam and Wang (forthcoming) document that
the U.S. real exchange rate exhibits substantially
different dynamics in response to surprise and expected changes in U.S. TFP. Following an expected
TFP increase, the real exchange rate appreciates
strongly on impact and continues to appreciate
for a few quarters before it begins converging back
to its initial level. Under the authors’ definition
of the real exchange rate, a decrease indicates
appreciation of the dollar. The response of the
real exchange rate to an expected increase in TFP
resembles a horizontal J-curve. By comparison,
the real exchange rate exhibits a hump-shaped
response to a favorable contemporaneous TFP
shock: It stays around its initial level on impact of
the shock, quickly increases above zero (depreciates) and remains significantly depreciated for
more than 12 quarters before converging back to
its initial level.
However, standard international macroeconomic models cannot replicate these documented
exchange rate behaviors following surprise and
expected productivity changes. The authors discuss challenges and potential solutions that would
allow standard models to match these empirical
findings. They also show that such a model will

14 FEDERAL RESERVE BANK OF DALLAS • Globalization and Monetary Policy Institute 2014 Annual Report

better match other dimensions of the data such as
the negative correlation between cross-country
relative consumption and the real exchange rate.
These studies have generated better understanding of exchange rate determination and lay the
groundwork for theoretical international macroeconomic models that provide more reliable
policy analysis involving open economic issues.

There is no strong
evidence that foreign
ownership can
induce productivity
gains for target firms
relative to domesticacquired firms.

Fons-Rosen et al. (2013) find that negative changes
in foreign ownership are also associated with
firm productivity improvement, consistent with
greater productivity arising from the ownership
change. Even though previous studies documented
performance gains following foreign acquisitions, it
remains unclear whether foreign ownership per se
is crucial for the gains. If a domestic entity acquired
the target firms, they might have exhibited a similar
International Capital Flows
performance improvement.
Recent research (Wang and Wang 2014) conWang and Wang (2014) compare the postsiders international capital flows and their impact acquisition performance changes for foreign- and
on host countries’ productivity, income and finan- domestic-acquired firms in China, which allows us
cial conditions, using firm-level data. Convento isolate the specific impact of foreign ownership
tional wisdom holds that foreign direct investment relative to domestic acquisitions. Although the
(FDI) can increase host countries’ productivity,
study uses Chinese data, the results likely apply to
both directly by introducing new technologies and other countries, especially other emerging markets.
indirectly by technology spillovers from FDI firms
Several findings stand out. First, there is
to domestic ones. As a result, many emerging
no strong evidence that foreign ownership can
markets provide tax and other incentives to attract induce productivity gains for target firms relative to
FDI, which has dramatically increased in these
domestic-acquired firms. If we compare foreign-acquired firms with domestic firms that experienced
countries over the past three decades.
no change in ownership, the result is significant
However, the authors find that FDI can
productivity gains for foreign-acquired firms in
be driven by foreign investors’ easy access to
the acquisition year and in subsequent years.
financial markets rather than their technological
advantages. Although numerous empirical studies These findings suggest that foreign acquisitions in
document the superior productivity performance China during the sample period did not differ from
domestic acquisitions with regard to productivity,
of FDI-involved plants and firms relative to their
even though both induced productivity gains over
domestic counterparts, the positive correlation
cannot be simply interpreted as a causal relation- companies whose ownership did not change.
ship. Instead, it may just reflect endogenous FDI
Second, foreign ownership significantly
decisions: Foreign investors choose to acquire
improved the financial condition (as measured by
or start business with more productive domestic
leverage and liquidity ratios) of target firms relative to domestic acquisitions. These results show
firms. For instance, Fons-Rosen et al. (2013) find
that following transactions, foreign-acquired firms
that FDI has a very small effect on target firms’
rely less on external short-term debt and more on
productivity in their sample of advanced European economies, after controlling for unobservinternal capital than domestic-acquired firms.
able factors that influence acquisition decisions.
Although several empirical studies cast
Even after controlling for endogenous choice doubt on the productivity benefits of FDI to
of FDI firms, a second issue remains for identifyadvanced economies, it may still be reasonable
ing performance gains from foreign ownership.
to believe the existence of such gains for FDI to
Previous studies found that foreign acquisition can emerging markets because these countries lag
improve target firm performance. However, numer- far behind in technology. However, the results
ous empirical studies document that domestic
suggest that even FDI to emerging markets could
mergers and acquisitions are also followed by sub- be mainly driven by financial advantages rather
stantial change in the performance of target firms.
than productivity advantages, casting doubt on
See Maksimovic and Phillips (2001) for a study on
the efficacy of tax and financial-benefit policies
productivity and McGuckin and Nguyen (2001)
intended to catch up to the technological frontier.
for a study on labor input and wages. In particular,
The data also indicate that FDI improves target

Globalization and Monetary Policy Institute 2014 Annual Report • FEDERAL RESERVE BANK OF DALLAS 15

firms’ exports, supporting the financial channel
of FDI in promoting international trade. Manova,
Wei and Zhang (forthcoming) find that FDI firms’
exports from China outperform domestic firms,
a finding that is more pronounced in financially
vulnerable sectors. Their results suggest that FDI
can mitigate financial constraints of firms in the
host countries, promoting exports and economic
growth. However, they do not examine the effect
of FDI on firm productivity. The results of Wang
and Wang (2014) complement Manova, Wei and
Zhang’s (forthcoming) findings by showing that
such a channel remains at work even after excluding the impact of domestic acquisition.
Foreign ownership is also found to increase
output, employment and wages of target firms
relative to domestic-acquired firms. This may
result from improved financial conditions leading
to increased sales and market share. The empirical
results suggest foreign ownership benefits the host
countries by strongly easing target firm financial
constraints, promoting their participation in
export activities, resulting in increases in output,
employment and labor incomes. However, Wang
and Wang (2014) do not find strong evidence that
foreign ownership increases firm productivity.
Many developing countries provide tax and
other incentives to attract FDI. The study shows
that FDI acquisitions promote host-country international trade by improving the finances of target
firms. Therefore, removing trade barriers through
free-trade agreements and World Trade Organization membership is a more effective strategy to
attract FDI. The results also suggest that FDI to
emerging markets such as China may reflect the
inefficiency of their financial markets. Government officials should not be overly concerned
with increasing FDI. Instead, emerging-market
leaders should reform financial markets rather
than provide tax or policy incentives to maintain
FDI.

Auer, Raphael (2012), “Exchange Rate Pass-Through,
Domestic Competition, and Inflation: Evidence from the
2005/08 Revaluation of the Renminbi,” CESifo Working
Paper no. 3759 (Munich: CESifo Group, March).

Matsumoto, Akito, Pietro Cova, Massimiliano Pisani and
Alessandro Rebucci (2011), “News Shocks and Asset Price
Volatility in General Equilibrium,” Journal of Economic
Dynamics and Control 35 (12): 2,132–49.

Beaudry, Paul, and Franck Portier (2006), “Stock Prices,
News, and Economic Fluctuations,” American Economic
Review, 96 (4): 1,293–307.

McGuckin, Robert H., and Sang V. Nguyen (2001), “The Impact of Ownership Changes: A View from Labor Markets,”
International Journal of Industrial Organization 19 (5):
739–62.

Beaudry, Paul, Deokwoo Nam and Jian Wang (2011), “Do
Mood Swings Drive Business Cycles and Is It Rational?”
Globalization and Monetary Policy Institute Working Paper
no. 98 (Federal Reserve Bank of Dallas, December).
Engel, Charles, and Jian Wang (2011), “International Trade
in Durable Goods: Understanding Volatility, Comovement,
and Elasticities,” Journal of International Economics 83 (1):
37–52.
Engel, Charles, and Kenneth D. West (2005), “Exchange
Rates and Fundamentals,” Journal of Political Economy 113
(3): 485–517.
Engel, Charles, Jian Wang and Jason Wu (2010), “LongHorizon Forecasts of Asset Prices When the Discount
Factor Is Close to Unity,” Globalization and Monetary Policy
Institute Working Paper no. 36 (Federal Reserve Bank of
Dallas, September).
Fons-Rosen, Christian, Sebnem Kalemli-Ozcan, Bent E.
Sørensen, Carolina Villegas-Sanchez and Vadym Volosovych
(2013), “Quantifying Productivity Gains from Foreign Investment,” NBER Working Paper no. 18920 (Cambridge, Mass:
National Bureau of Economic Research, March).
Juvenal, Luciana (2011), “Sources of Exchange Rate Fluctuations: Are They Real or Nominal?” Journal of International
Money and Finance 30 (5): 849–76.
Kim, Mina, Deokwoo Nam, Jian Wang and Jason Wu (2013),
“International Trade Price Stickiness and Exchange Rate PassThrough in Micro Data: A Case Study on U.S.–China Trade,”
Globalization and Monetary Policy Institute Working Paper
no. 135 (Federal Reserve Bank of Dallas, August).
Maksimovic, Vojislov, and Gordon Phillips (2001), “The
Market for Corporate Assets: Who Engages in Mergers and
Asset Sales and Are There Efficiency Gains?” Journal of
Finance 56 (6): 2,019–65.

References
Amiti, Mary, Oleg Itskhoki and Jozef Konings (2014),
“Importers, Exporters, and Exchange Rate Disconnect,”
American Economic Review 104 (7): 1,942–78.

Manova, Kalina, Shang-Jin Wei and Zhiwei Zhang (forthcoming), “Firm Exports and Multinational Activity under
Credit Constraints,” Review of Economics and Statistics.

An, Lian, and Jian Wang (2012), “Exchange Rate PassThrough: Evidence Based on Vector Autoregression with
Sign Restrictions,” Open Economies Review 23 (2): 359–80.

Marazzi, Mario, and Nathan Sheets (2007), “Declining
Exchange Rate Pass-Through to U.S. Import Prices: The
Potential Role of Global Factors,” Journal of International
Money and Finance 26 (6): 924–47.

Meese, Richard A., and Kenneth Rogoff (1983), “Empirical
Exchange Rate Models of the Seventies: Do They Fit Out
of Sample?” Journal of International Economics 14 (1–2):
3–24.
Mumtaz, Haroon, Ozlem Oomen and Jian Wang (2011), “Exchange Rate Pass-Through into U.K. Import Prices: Evidence
from Disaggregated Data,” Federal Reserve Bank of Dallas
Staff Papers, no. 14.
Nakamura, Emi, and Jón Steinsson (2012), “Lost in Transit:
Product Replacement Bias and Pricing to Market,” American
Economic Review 102 (7): 3,277–316.
Nam, Deokwoo, and Jian Wang (forthcoming), “The Effects
of Surprise and Anticipated Technology Changes on International Relative Prices and Trade,” www.dallasfed.org/assets/documents/institute/events/2013/527Wangpaper.pdf.
Revision of “The Effects of News About Future Productivity
on International Relative Prices: An Empirical Investigation,”
Globalization and Monetary Policy Institute Working Paper
no. 64 (Federal Reserve Bank of Dallas, October 2010).
Shambaugh, Jay (2008), “A New Look at Pass-Through,”
Journal of International Money and Finance 27 (4): 560–91.
Wang, Jian (2010a), “Durable Goods and the Collapse of
Global Trade,” Federal Reserve Bank of Dallas Economic
Letter 5 (2).
_________ (2010b), “Home Bias, Exchange Rate Disconnect, and Optimal Exchange Rate Policy,” Journal of
International Money and Finance 29 (1): 55–78.
Wang, Jian, and Xiao Wang (2014), “Benefits of Foreign
Ownership: Evidence from Foreign Direct Investment in
China,” Globalization and Monetary Policy Institute Working
Paper no. 191 (Federal Reserve Bank of Dallas, September).
Wang, Jian, and Jason Wu (2012), “The Taylor Rule and
Forecast Intervals for Exchange Rates,” Journal of Money,
Credit and Banking 44 (1): 103–44.

16 FEDERAL RESERVE BANK OF DALLAS • Globalization and Monetary Policy Institute 2014 Annual Report

Toward a Better Understanding of
Macroeconomic Interdependence
By Alexander Chudik

The concept of
a representative
foreign economy
has no proper
justification in the
literature, and the
consequences of
aggregating the rest
of the world into
one representative
economy are not fully
understood.

he Globalization and Monetary
Policy Institute’s mission is promoting research that helps the public
better understand how globalization affects the conduct of U.S. monetary policy.
Determining the consequences of trade and
financial globalization is challenging. Understanding macroeconomic interdependence is necessary
to fully comprehend globalization’s consequences.
This touches on a number of fields, including theoretical open economy macroeconomic research,
empirical data-driven applied research and development of new econometric tools to handle large
international datasets.
This article examines how my work has contributed to the institute’s mission, particularly to our
understanding of macroeconomic interdependence.
This essay is in three parts. The first reviews how theoretical open economy macroeconomic modeling
helps assess interdependence. Specifically, it identifies shortcuts used in the literature that may be misleading. The second part summarizes contributions
regarding development of new econometric tools for
modeling interdependent economies, including use
of the global vector autoregressive (GVAR) approach.
In the final part, I review applications developed with
the GVAR approach, a modeling technique widely
used to measure how economic shocks affect interdependent economies.
These efforts would not be possible without
my coauthors at the European Central Bank
(ECB), Banque de France, International Monetary
Fund (IMF) and various academic institutions.
Part 1:
Theoretical Open Economy
Macroeconomic Modeling

Economists strongly prefer simplicity
and seek to develop models requiring minimal

structure to analyze a given question. This is
understandable, since comprehending the innerworkings of a relatively uncomplicated economic
model is easier than working with something
overly complex. Because of this desire for simplicity, mainstream open economy macroeconomic
models typically feature just two economies—a
domestic economy and a representative foreign
economy—rather than a multilateral setting of
many economies.
However, the concept of a representative
foreign economy has no proper justification in
the literature, and the consequences of aggregating the rest of the world into one representative
economy are not fully understood. In an institute
working paper (Chudik and Straub 2011), we
sought to fill this gap. We developed a multicountry general equilibrium model that helps investigate conditions under which aggregating foreign
economies into a single representative foreign
economy would be reasonable.1 The findings are
quite surprising, but intuitive.
We found that the concept of a representative single economy could produce misleading
conclusions. For instance, an increase in trade
openness in two-country models is commonly
associated with an increase in dependence of
the domestic economy on foreign idiosyncratic
shocks. In contrast, we found that in a multicountry model, the degree of macroeconomic
interdependence is not necessarily connected
to the notion of trade openness, as usually contemplated. Instead, we found that the degree of
foreign trade diversification is key.
Specifically, diversification of foreign trade
can help reduce the impact on the domestic
economy from idiosyncratic shocks in foreign
economies. The main intuition for this result is
quite simple: We can draw analogies with finance

Globalization and Monetary Policy Institute 2014 Annual Report • FEDERAL RESERVE BANK OF DALLAS 17

literature on portfolio diversification. It is understood that idiosyncratic risk is irrelevant for a
well-diversified portfolio; only systemic risk matters. The same applies in a multicountry macro
model, where the dependence of a domestic
economy on foreign idiosyncratic shocks is
mitigated by diversifying trade flows. However, it
is clear that diversification of trade and financial
flows would not insulate a country from global
systemic events.
Second, we found that the concept of a
representative foreign economy can result in
a sizable bias due to aggregation of rest-of-theworld economies. This is perhaps less surprising,
since there are large heterogeneities across individual economies in the world. The two-country
approximation in the literature is especially
poor when trade and financial flows are not well
diversified across economies. This suggests that
the two-country framework is consequently
not a good approximation for many small open
economies with a sizable exposure to the U.S. or
to another large economy. In another institute
working paper, Ca’ Zorzi and Chudik (2013)
documented the size of this type of aggregation
bias in the question of international price convergence (an issue that has puzzled economists
for many decades). We found that, depending on
how the foreign economies are aggregated in a
single representative rest-of-the-world economy,
the estimates of the speed of price convergence
may be biased by a very large degree. This bias
could overshadow all the others identified in the
literature.
Last, two-country models are insufficient
for studying how real or financial shocks transmit
across economies in a globalized world.
Taken together, these arguments suggest
abandoning the restrictive two-country frame-

work to more fully comprehend the consequences of globalization. In particular, estimating the
impact of U.S. monetary policy on the rest of the
world and the repercussions in the U.S. should be
based on a multicountry model.
Theoretical multicountry DSGE models
(for example, the EAGLE model at the ECB,
or the SIGMA model at the Federal Reserve
Board) are quite useful in solving important
policy questions, including welfare analysis. But
moving to more than two economies comes
at a great cost in terms of model transparency.
This weighs heavily on the usefulness of large
theoretical models for policy analysis, since the
role of individual assumptions becomes more
difficult to ascertain, and the answers these
models provide are effectively hardwired in the
underlying assumptions. Furthermore, theoretical macroeconomic multicountry models
impose many restrictions that the data may not
support. Therefore, theoretical models should be
accompanied by coherent and pragmatic empirical global models capable of handling interdependent economies. Empirical models could
also help us better understand different features
of large international datasets and could provide
stylized facts and new empirical puzzles, which
theory could then seek to explain.
Part 2:
Empirical Global Macroeconomic
Modeling

The main challenge faced when building
empirical models of interdependent economies
is the large number of variables involved. For example, one can focus on the 30 largest economies,
accounting for more than 90 percent of world
output. However, even with a few key macroeconomic variables per economy—short- and

It is clear that
diversification of
trade and financial
flows would not
insulate a country
from global systemic
events.

18 FEDERAL RESERVE BANK OF DALLAS • Globalization and Monetary Policy Institute 2014 Annual Report

We have contributed
a number of
methodological
breakthroughs
involving large
datasets. We
provided new
results on estimation
and inference in
panels featuring
interdependent
economies.

long-term interest rates, consumer price inflation,
real gross domestic product (GDP), equity price
index and exchange rate—the overall number of
variables in the global model would require an
overwhelmingly large dataset. The number of unknown parameters to be estimated in unrestricted
empirical models—those models not based on
theoretical relationships, that accurately describe
the data—generally grows at a quadratic rate with
the number of variables. Therefore, given that
typical macro datasets do not cover more than
three to five decades of quarterly data, empirical
multicountry models cannot be estimated without
imposing restrictions on a model’s parameters.
This problem is also known as the “curse of dimensionality.”2
The literature recognizes that the standard
econometric tools are insufficient for large international datasets due to the curse of dimensionality. With increasing interest in the modeling of the
global economy in addition to greater availability
of large international datasets, research over
the last decade has looked at developing new
econometric tools that can handle interdependent economies. The key challenge is avoiding
imposing restrictions that would be considered
inappropriate in a globalized world, while, at the
same time, being parsimonious so that individual
parameters can be reliably estimated.
We have contributed a number of methodological breakthroughs involving large datasets.
We provided new results on estimation and
inference in panels featuring interdependent
economies (Chudik et al. 2014; Chudik and Pesaran forthcoming). We studied the consequences
of aggregation in a global context (Chudik and
Pesaran 2014a; Chudik, Ca’ Zorzi and Dieppe
2012) and provided a statistical characterization
of the pattern of dependence across individual
cross-sectional units (be they individual economies in the global economy or other types of units,
such as households, firms, sectors or regions),
which, unlike the time dimension, does not have
any natural ordering (Chudik, Pesaran and Tosetti
2011). Additionally, we contributed to the methodological foundations of the GVAR approach in
the literature (Chudik and Pesaran 2011, 2013;
Chudik and Smith 2013).

Part 3:
The GVAR Approach and Its
Applications

The global VAR approach was originally
proposed by Hashem Pesaran and his coauthors
in the aftermath of the 1997 Asian financial crisis.
It became clear that major financial institutions
were exposed to risks from adverse global or
regional macro shocks. Simulating these effects
required a coherent and transparent global model.
The original aim was to develop such a model to
quantify the effects of macroeconomic developments on the losses of systemically important
financial institutions.
The solution to the curse of dimensionality in this approach is quite simple and can be
described in two steps. In the first, a small scale
model for each country is estimated separately.
These individual country models include domestic variables, globally dominant variables (such
as the price of oil) and country-specific weighted
cross–section averages of foreign variables. In the
second step, all estimated models are stacked and
solved in one large system (or GVAR) featuring all
variables. The GVAR model is coherent and easy to
use for scenario analysis and forecasting.
Although developed originally for credit risk
analysis, the GVAR approach has numerous other
applications. In an institute working paper, Chudik
and Pesaran (2014b) survey the methodological
foundations and empirical applications of the
GVAR approach. We reviewed about 60 academic
empirical papers that use GVAR. Institutions,
including the IMF and the ECB, have used the approach as well.3 At the institute, we developed four
applications of the GVAR approach.
In Bussière, Chudik and Mehl (2013), we
used a GVAR model to uncover how shifts in risk
appetite and other shocks influence real effective
exchange rates. The Japanese yen, Swiss franc
and U.S. dollar are familiar safe-haven currencies
facing significant appreciation pressure when risk
appetite declines. Such was the case following the
Lehman Brothers failure in 2008, the 9/11 attacks,
and the Russian and Long-Term Capital Management crises in 1998. We found that before the start
of Economic and Monetary Union (EMU) in 1999,
the Deutsche mark also played an important safehaven role, which is not surprising. In contrast, we

Globalization and Monetary Policy Institute 2014 Annual Report • FEDERAL RESERVE BANK OF DALLAS 19

The Japanese yen, Swiss franc
and U.S. dollar are familiar safehaven currencies facing significant
appreciation pressure when risk
appetite declines. Such was the
case following the Lehman Brothers
failure in 2008, the 9/11 attacks, and
the Russian and Long-Term Capital
Management crises in 1998.

Chart 1
Global Exports Increase as U.S. Output Rises
Percent
3

–1

–3

U.S.
Canada
Singapore
Thailand
Mexico
France
Switzerland
Argentina
U.K.
Sweden
Italy
Korea
Spain
Germany
Netherlands
Japan
New Zealand
Norway
China
Australia
Brazil

–2

Europe
Asia
L. America

learned that following the start of the EMU, the
euro tended to depreciate in response to a decline
in risk appetite. Another key finding from this empirical exercise is that the divergence in external
competitiveness among euro-area countries over
the last decade was more likely due to countryspecific shocks, as opposed to global shocks
with asymmetric effects on individual euro-area
member states.
In Chudik and Fratzscher (2011, 2012), we
employed weekly financial data on bonds, stocks
and currencies to investigate how key shocks—to
liquidity and risk—are transmitted across global
financial markets. Additionally, we attempted to
identify the determinants that explain differences
in transmission of shocks across countries. In particular, we investigated to what extent external exposure (either through trade or financial linkages)
or idiosyncratic, country-specific characteristics
(such as countries’ macroeconomic fundamentals and perceived riskiness) made countries
vulnerable to different types of shocks. We found
that transmission of liquidity and risk shocks is
highly heterogeneous—across countries, across
asset classes and over time. Moreover, we found
that countries’ sovereign credit ratings, quality of
institutions and financial exposure are important
determinants of cross-country transmission pattern differences.
In Bussière, Chudik and Sestieri (2012), we
applied the GVAR approach to investigate the underlying factors of global trade flows using data on
21 advanced and emerging economies. The results
suggest that relative demand terms, as opposed
to relative prices (exchange rates), tend to have a
much stronger effect on trade flows. This finding is
in line with observations following the 2008 financial crisis—that the adjustment in global imbalances was not associated with a sharp depreciation
of the dollar (contrary to what many observers
expected). In the model, a positive shock to U.S.
domestic output—for example, an unexpected rise
in GDP—profoundly affected foreign countries’
exports as well as their output expansion, which in
turn positively affected U.S. exports (Chart 1).
By comparison, a positive shock to the U.S.
real effective exchange rate, which immediately
strengthens the dollar by about 2.5 percent, has
an unambiguous negative effect on U.S. exports

NOTE: This chart shows the impact of a positive U.S. output shock on exports after one year
with 90 percent confidence bounds. The size of the shock is one standard error (a size considered statistically typical), which is equal to 0.6 percent of U.S. GDP at the time of impact.
SOURCE: “Modeling Global Trade Flows: Results from a GVAR Model,” by M. Bussière, A.
Chudik and G. Sestieri, Globalization and Monetary Policy Institute Working Paper no. 119
(Federal Reserve Bank of Dallas, June 2012).

20 FEDERAL RESERVE BANK OF DALLAS • Globalization and Monetary Policy Institute 2014 Annual Report

Macroeconomic
interdependence
is a challenging
and active field of
economics research
with much more to
discover.

(which fall 1.3 percent in the first year) and a
strong positive effect on Japan and European
countries’ exports (Chart 2), Bussière, Chudik and
Sestieri (2012) also argued.
We argued that the GVAR model is helpful
for monitoring trade flows and can be used to
understand the so-called Great Trade Collapse
(GTC). World exports contracted more than 6
percent in fourth quarter 2008 and 10 percent in
first quarter 2009, a drop that was sharp, sudden and synchronized. In the past few years, the
GTC has stimulated a wealth of theoretical and
empirical research. We compared the observed
decline during the GTC with the model’s prediction, conditioned on the observed values for real
output and real exchange rates. We found that the
observed fall in demand and the change in global
foreign exchange rates alone could not explain the
GTC, which suggests that other factors, such as
trade credit and finance, may have played a role.
In an institute working paper by Chudik,
Grossman and Pesaran (2014), we also used the
GVAR approach to investigate the value of the

Chart 2
U.S. Dollar Appreciation Felt Most in Japan and Europe
Percent
2
1.5
1

PMI (formally called the Purchasing Managers’
Index) for forecasting global (48 countries) output
growth. GDP data are available with a substantial
release lag (one to three quarters, depending on an
individual economy); PMIs are more timely. Moreover, there is great similarity between PMIs and
quarterly output growth. However, PMI usefulness
as a forecasting tool of output growth—over and
above what past output growth data say about
future performance—can only be ascertained
using conditional models, with and without PMIs.
We found that PMIs contribute a 15–20 percent
improvement in forecasting performance for
output growth projections in the current quarter.4
By comparison, when forecasting output growth
in the next quarter or across longer horizons, PMIs
aren’t very helpful.
Researching Interdependence

Understanding macroeconomic interdependence
is a difficult research problem and essential for
assessing the consequences of globalization
for the conduct of U.S. monetary policy. Since
joining the institute in 2011, I have worked with
a network of coauthors developing theoretical
multicountry macroeconomic models, pioneering new econometric tools for large international
datasets and applying these methods with the
aim of better understanding the interdependence
of individual economies in the global economy.
Macroeconomic interdependence is a challenging
and active field of economic research with much
more to discover.

Notes

0
–.5
-1
–1.5

Japan
Germany
Spain
Australia
France
Switzerland
U.K.
Norway
Italy
Thailand
China
Canada
Mexico
Netherlands
Argentina
Sweden
New Zealand
Singapore
Korea
Brazil
U.S.

–2.5

Europe
Asia
L. America

–2

NOTE: This chart shows the impact of a U.S. exchange rate shock on exports after one
year with 90 percent confidence bounds. The size of the shock is one standard error (a size
considered statistically typical), which is equal to 2.5 percent appreciation of the U.S. dollar at
the time of impact.
SOURCE: “Modeling Global Trade Flows: Results from a GVAR Model,” by M. Bussière, A.
Chudik and G. Sestieri, Globalization and Monetary Policy Institute Working Paper no. 119
(Federal Reserve Bank of Dallas, June 2012).

1
In particular, we have developed a multicountry dynamic
stochastic general equilibrium (DSGE) model. DSGE modeling is a branch of general equilibrium theory that is influential in contemporary macroeconomics.
2
This expression was coined by Richard E. Bellman when
considering problems in dynamic optimization.
3
See the following IMF policy publications for examples
of use of the GVAR approach by IMF staff: 2011 and 2014
Spillover Reports; 2006 World Economic Outlook; October
2010 and April 2014 Regional Economic Outlook: Asia and
Pacific Department; April 2014 Regional Economic Outlook:
Western Hemisphere Department; November 2012 Regional
Economic Outlook: Middle East and Central Asia Department; October 2008 Regional Economic Outlook: Europe;
April and October 2012 Regional Economic Outlook: SubSaharan Africa; and IMF country reports for Algeria, India,

Globalization and Monetary Policy Institute 2014 Annual Report • FEDERAL RESERVE BANK OF DALLAS 21

Italy, Russia, Saudi Arabia, South Africa and Spain.
4
As measured by the GDP-weighted average mean square
forecast error.

———— (2014b), “Theory and Practice of GVAR Modeling,” Globalization and Monetary Policy Institute Working
Paper no. 180 (Federal Reserve Bank of Dallas, May).

References

———— (forthcoming), “Common Correlated Effects Estimation of Heterogeneous Dynamic Panel Data Models with
Weakly Exogenous Regressors,” Journal of Econometrics.

Bussière, M., A. Chudik and A. Mehl (2013), “How Have
Global Shocks Impacted the Real Effective Exchange
Rates of Individual Euro Area Countries Since the Euro’s
Creation?” The B.E. Journal of Macroeconomics 13: 1–48.
Bussière, M., A. Chudik and G. Sestieri (2012), “Modeling
Global Trade Flows: Results from a GVAR Model,” Globalization and Monetary Policy Institute Working Paper no. 119
(Federal Reserve Bank of Dallas, June).
Ca’ Zorzi, M., and A. Chudik (2013), “Spatial Considerations
on the PPP Debate,” Globalization and Monetary Policy
Institute Working Paper no. 138 (Federal Reserve Bank of
Dallas, January).
Chudik, A., M. Ca’ Zorzi and A. Dieppe (2012), “The Perils
of Aggregating Foreign Variables in Panel Data Models,”
Globalization and Monetary Policy Institute Working Paper
no. 111 (Federal Reserve Bank of Dallas, March).
Chudik, A., and M. Fratzscher (2011), “Identifying the Global
Transmission of the 2007–09 Financial Crisis in a GVAR
Model,” European Economic Review 55 (3): 325–39.
———— (2012), “Liquidity, Risk and the Global Transmission of the 2007–08 Financial Crisis and the 2010–11
Sovereign Debt Crisis,” Globalization and Monetary Policy
Institute Working Paper no. 107 (Federal Reserve Bank of
Dallas, January).
Chudik, A., V. Grossman and M.H. Pesaran (2014), “A MultiCountry Approach to Forecasting Output Growth Using
PMIs,” Globalization and Monetary Policy Institute Working
Paper no. 213 (Federal Reserve Bank of Dallas, December).
Chudik, A., K. Mohaddes, M.H. Pesaran and M. Raissi
(2013), “Debt, Inflation and Growth: Robust Estimation of
Long-Run Effects in Dynamic Panel Data Models,” Globalization and Monetary Policy Institute Working Paper no. 162
(Federal Reserve Bank of Dallas, November).
Chudik, A., and M.H. Pesaran (2011), “Infinite Dimensional
VARs and Factor Models,” Journal of Econometrics 163 (1):
4–22.
———— (2013), “Econometric Analysis of High Dimensional VARs Featuring a Dominant Unit,” Econometric
Reviews 32 (5–6): 592–649.
———— (2014a), “Aggregation in Large Dynamic Panels,” Journal of Econometrics 178 (Part 2): 273–85.

Chudik, A., M.H. Pesaran and E. Tosetti (2011), “Weak and
Strong Cross Section Dependence and Estimation of Large
Panels,” Econometrics Journal 14 (1): C45–C90.
Chudik, A., and V. Smith (2013), “The GVAR Approach and
the Dominance of the US Economy,” Globalization and
Monetary Policy Institute Working Paper no. 136 (Federal
Reserve Bank of Dallas, January).
Chudik, A., and R. Straub (2011), “Size, Openness, and Macroeconomic Interdependence,” Globalization and Monetary
Policy Institute Working Paper no. 103 (Federal Reserve
Bank of Dallas, December).

22 FEDERAL RESERVE BANK OF DALLAS • Globalization and Monetary Policy Institute 2014 Annual Report

Summary of Activities 2014

“The Federal
Reserve’s Role in
the Global Economy:
A Historical
Perspective”
was the Bank’s
flagship centennial
conference.

he Globalization and Monetary
Policy Institute passed an important milestone in 2014 with the
publication of the 200th working
paper in its dedicated working paper series. The
paper—“The Federal Reserve in a Globalized
World Economy”—was authored by the chairman
of our advisory board, John Taylor. It was among
the papers presented at a conference the institute
organized as part of the Federal Reserve System’s
centennial observances this past year. Indeed, 2014
was a bumper year for the institute’s working paper
series, with 54 new papers circulated, bringing the
total number in the series as of year-end to 220.
Total downloads of the institute’s working papers
increased from 2,207 in 2013 to 2,781 in 2014.
Abstract views totaled 6,617 in 2014.
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.

Modeling,” coauthored with Hashem Pesaran; and
Journal of Economic and Social Measurement:
Enrique Martínez-García and Valerie Grossman’s
“A New Database of Global Economic Indicators
(DGEI),” coauthored with Adrienne Mack.
At year-end, staff had papers under review at
the Review of Economics and Statistics, Journal
of Applied Econometrics, International Economic
Review, Journal of Econometrics, Journal of
International Economics, Journal of Monetary
Economics, Journal of Money, Credit and Banking, Journal of International Money and Finance,
Journal of Financial Economics, Journal of Real
Estate Finance and Economics and Economic
Inquiry.
Conferences

The institute organized three conferences
during 2014, one with Shanghai University of
Finance and Economics (SHUFE), one with the
Tower Center at Southern Methodist University
and the conference held to mark the Federal
Academic Research
Reserve System’s centennial. The first, “MicroJournal acceptances in 2014 were up from
Foundations of International Trade, Global Imbalances and Implications on Monetary Policy,” was
2013, when one paper was accepted for publication. Seven papers were accepted for publication
held in Shanghai in March and was cosponsored
in 2014—in the Journal of Monetary Economics:
with SHUFE. This is the third such conference that
Scott Davis’ “Financial Integration and International we have organized in Shanghai in recent years
Business Cycle Co-Movement”; Economics Letters: (two with SHUFE, one with Fudan University).
Jian Wang’s “Are Predictable Improvements in TFP The 2014 conference featured presentations by
Contractionary or Expansionary: Implications
researchers from the University of British Columbia, Johns Hopkins University, Dartmouth College,
from Sectoral TFP?” coauthored with Deokwoo
Nam; European Economic Review: Michael Sposi’s Chinese University of Hong Kong, SHUFE and the
Dallas Fed.
“Price Equalization, Trade Flows, and Barriers to
The second conference, “The Political
Trade,” coauthored with Piyusha Mutreja and B.
Economy of International Money: Common CurRavikumar; Journal of Econometrics: Alexander
rencies, Currency Wars and Exorbitant Privilege,”
Chudik’s “Common Correlated Effects Estimation
was held at the Dallas Fed on April 3–4. This conof Heterogeneous Dynamic Panel Data Models
ference was organized by institute Director Mark
with Weakly Exogenous Regressors,” coauthored
Wynne and Kathleen Cooper of the Tower Center
with Hashem Pesaran; Advances in Econometrics volume: Enrique Martínez-García and Mark
at Southern Methodist University and was funded
Wynne’s “Assessing Bayesian Model Comparison
in part by the Jno. Owens Foundation. Keynote
in Small Samples”; Journal of Economic Surveys:
speeches were delivered by the late Ronald McAlexander Chudik’s “Theory and Practice of GVAR
Kinnon of Stanford University (one of the fathers

Globalization and Monetary Policy Institute 2014 Annual Report • FEDERAL RESERVE BANK OF DALLAS 23

of the theory of optimum currency areas) and
Jeffry Frieden of Harvard University.
The third conference, “The Federal Reserve’s
Role in the Global Economy: A Historical Perspective,” was the Bank’s flagship centennial conference,
held Sept. 18–19. The conference was organized
by institute Director Wynne and senior fellow
Michael Bordo and featured senior policymakers
and academics, including former Banco de México
Governor Guillermo Ortiz, former Federal Reserve
Vice Chair Donald Kohn and former Bank of England Deputy Governor Charles Bean. The inaugural
Roosa Lecture was also part of the conference
and was delivered by former Fed Chairman Paul
Volcker. Summaries of all three conferences are
included elsewhere in this report.
As in previous years, staff members were
active presenting their work in external forums
and conferences in 2014. These included the XVII
Workshop in International Economics and Finance,
the Association of Private Enterprise Education,
the Tsinghua PBCSF Global Finance Forum, the
Conference on Global Capital Flows and Financial
Risk Management, the 2014 Spring Midwest Macro
Meetings, the 2014 Western Economics Association
International (WEAI) meetings and the International Conference on Financial Market Reform and
Market Regulation.
Additionally, staff presented at the 10th
Dynare Conference, the fall 2014 Midwest Macro
Meeting, the 61st North American meetings of the
Regional Science Association International, the
Federal Reserve System Committee on International Economic Analysis and the Southern Economic
Association 84th annual meetings.
Staff members also presented their work in
seminars at the University of Houston, University of
Winnipeg, Tsinghua University, Seoul National University, University of North Carolina at Charlotte,
Texas A&M University, Beijing University, Southern
University of Finance and Economics, Hong Kong
Monetary Authority, Emory University, Bank of
England, Bank for International Settlements and
the Swiss National Bank.

Bank Publications

Institute staff contributed five articles to the
Bank’s Economic Letter publication during the
year: “Deindustrialization Redeploys Workers to
Growing Service Sector,” by Michael Sposi and
Valerie Grossman; “China’s Sputtering Housing
Boom Poses Broad Economic Challenge,” by Janet
Koech and Jian Wang; “Central Bank Transparency
Anchors Inflation Expectations,” by J. Scott Davis,
Adrienne Mack and Mark A. Wynne; “Consumer
Price Differences Persist Among Eight Texas Cities,”
by Alexander Chudik (and Michele Ca’ Zorzi of
the European Central Bank and Chi-Young Choi of
the University of Texas at Arlington); and “Current
Account Surplus May Damp the Effects of China’s
Credit Boom,” by J. Scott Davis and Adrienne Mack
(and Wesley Phoa and Anne Vandenabeele of the
Capital Group Cos.). The Bank’s Economic Letter
and this annual report are intended to disseminate
research to a broader audience than technical
experts in economics.
People

Julieta Yung, a recent PhD graduate from the
University of Notre Dame, joined the staff in July as
a research economist. Bradley Graves, a 2014 graduate of SMU, joined the staff as a research assistant
in June, and Kuhu Parasrampuria, a 2013 graduate
of the University of Rochester, joined the staff as a
research assistant in July. Senior Research Analyst
Adrienne Mack left the staff to take a position as an
actuary with Mutual of Omaha. Scott Davis spent
the month of July visiting the Hong Kong Institute
for Monetary Research. In addition to regular visits
over the year by Advisory Board member Finn
Kydland and senior fellows Michael Bordo, Mario
Crucini, Michael Devereux and Karen Lewis, we
hosted research associate Ippei Fujiwara for a week
in Dallas.
This year, we added four research associates
to our network: C.Y. Choi (University of Texas at
Arlington), German Cubas (University of Houston),
Piyusha Mutreja (Syracuse University) and Heiwai
Tang (Johns Hopkins University).

24 FEDERAL RESERVE BANK OF DALLAS • Globalization and Monetary Policy Institute 2014 Annual Report

Micro-Foundations of International Trade,
Global Imbalances and Implications on
Monetary Policy
By Jian Wang

2014 Conference Summary
When: March 15–16
Where: Shanghai University of Finance and
Economics (SHUFE), Shanghai, China
Sponsors: Federal Reserve Bank of Dallas’
Globalization and Monetary Policy Institute;
School of International Business Administration
at Shanghai University of Finance and Economics

esearchers from the U.S., Canada
and China gathered in Shanghai to
explore exchange rates, offshoring
and trade policies. Research presented at the conference employed microdata of trade
volumes and prices at the firm and product levels,
which provide valuable information on crucial
global economic issues such as trade imbalances,
economic development and wage inequality.
Conference organizers were Jian Wang of the
Federal Reserve Bank of Dallas and Zhi Yu of the
Shanghai University of Finance and Economics
(SHUFE). Presenters’ institutions included the
University of British Columbia, Johns Hopkins
University, Dartmouth College, Chinese University of Hong Kong, SHUFE and the Dallas Fed.

empirical findings as the exchange rate response
puzzle. It suggests that developing and advanced
economies’ transmission mechanisms may differ.
Furthermore, Hnatkovska, Lahiri and Vegh
modify standard international macroeconomic
models to introduce three impacts of monetary
policy: the liquidity demand effect, fiscal effect and
output effect. These three work in differing ways
on the exchange rate following monetary tightening. The authors argue that the exchange rate
response puzzle is attributable to the difference
between developing and developed economies in
the relative strength of these three effects.
Under the liquidity demand effect, an
increase in the interest rate reduces the amount
of the money in circulation, appreciating the exchange rate. However, under the fiscal and output
Session One:
effects, an increase in the current interest rate will
Exchange Rates and Capital Goods
raise the fiscal burden either through a higher
The first session considered exchange rate
interest rate on government debt or reduced
determination, the pass-through of exchange rate government revenue in the future. The increase in
changes to prices and international trade in capital the fiscal burden could be balanced by an increase
goods. Viktoria Hnatkovska, an associate professor in the inflation rate (inflation tax), which depreciates a country’s currency. Hnatkovska, Lahiri and
at the University of British Columbia, presented
“The Exchange Rate Response Puzzle,” coauthored Vegh argue that the fiscal and output effects are
stronger in developing countries than in industrial
with Amartya Lahiri, a professor of economics
economies because emerging economies rely
at the University of British Columbia, and Carlos
more on inflation tax—accounting for why the
Vegh, a professor of economics at the University
exchange rate responds differently to monetary
of Maryland. The authors investigated the effect
tightening.
of monetary tightening on the nominal exchange
Xiang Gao, an assistant professor of economrate. Various theoretical models predict that the
ics at SHUFE, provided commentary, noting that
exchange rate appreciates following a rise in the
reverse causality may exist in the data. Many
policy rate, and that prediction has been widely
central banks in emerging economies take action
confirmed in previous empirical studies that use
to stabilize their currencies. For instance, they ofthe data from advanced countries. Hnatkovska,
ten raise the interest rate when the exchange rate
Lahiri and Vegh document that the exchange
depreciates and vice versa. He recommended the
rate depreciates in developing countries following a monetary tightening, while it appreciates in
authors consider alternative strategies to identify
industrial countries. The authors referred to these exogenous monetary shocks as robustness checks

Globalization and Monetary Policy Institute 2014 Annual Report • FEDERAL RESERVE BANK OF DALLAS 25

of their empirical findings.
Wang of the Dallas Fed presented the session’s second paper, “International Trade Price
Stickiness and Exchange Rate Pass-Through in
Micro Data: A Case Study on U.S.–China Trade,”
coauthored with Mina Kim, a research economist
at the Bureau of Labor Statistics (BLS); Deokwoo
Nam, an assistant professor at Hanyang University
in Seoul, South Korea; and Jason Wu, a section
chief at the Board of Governors of the Federal
Reserve System. The paper examined the effect
of the renminbi appreciation on trade prices
between the U.S. and China. Using goods-level
prices collected by the BLS, two empirical findings
were proposed. First, firms changed prices more
frequently after China abandoned its hard peg to
the U.S. dollar in June 2005, allowing the Chinese
currency to appreciate against the dollar. The duration of U.S.–China trade prices declined almost
30 percent after June 2005. A benchmark menu

cost model calibrated to the data can replicate the
decrease in price stickiness.
Second, data on goods-level prices shed
additional light on the manner in which renminbi
appreciation has been passed on to U.S. import
prices—exchange rate pass-through, or ERPT. Using goods-level price data, the paper documented
that around 40 percent of U.S. imported goods
from China were replaced without a single price
change. These goods are more likely to change
prices through product replacement rather than
regular price adjustment. ERPT becomes much
higher after exclusion of goods with no price
change in the data, indicating that studies that
do not consider product replacement bias may
underestimate the effect of renminbi appreciation
on U.S. import prices.
Shu Lin, a professor of economics at Fudan
University, discussed the paper, finding the
increase in the occurrence of price changes very

Most world capital
goods production
is concentrated in
a small number of
countries, and poor
countries mainly
rely on imported
capital goods
for their capital
accumulation.

Participants in the microfoundations conference

26 FEDERAL RESERVE BANK OF DALLAS • Globalization and Monetary Policy Institute 2014 Annual Report

interesting and wondering if the frequency of
product replacements also increased after China
abandoned the hard currency peg. Lin also
recommended that the authors investigate other
potential reasons for low ERPT. For instance,
China imports a large fraction of its inputs for producing final exports. When the Chinese currency
appreciated, the prices of imported inputs became
cheaper, reducing pressure on Chinese exporters
to increase their prices.
Michael Sposi, a research economist at the
Dallas Fed, presented “Capital Goods Trade and
Economic Development,” coauthored with Piyusha Mutreja, an assistant professor of economics
at Syracuse University, and B. Ravikumar, a vice
president at the Federal Reserve Bank of St. Louis.
Most world capital goods production is concentrated in a small number of countries, and poor
countries mainly rely on imported capital goods
for their capital accumulation. Mutreja, Ravikumar
and Sposi argue that trade barriers will hinder developing countries from importing capital goods
and slow their economic growth.
The authors introduce a multicountry,
multisector Ricardian model of trade, in which
one country has comparative advantage producing capital goods, into a neoclassical growth
framework and calibrate the model to bilateral
trade flows, prices and income per worker. Their
model can match the data in multiple dimen-

Professor Emily Blanchard
speaking to the conference

sions such as the world distribution of capital
goods production and the variation in capital per
worker across countries. The model predicts that
the cross-country income differences fall by more
than 50 percent when distortions to capital goods
trade are removed.
David Cook, a professor of economics at
Hong Kong University of Science and Technology,
noted during his discussion of the paper that the
authors challenge the conventional view on the
low investment rates in less-developed countries.
It is believed that the high relative cost of capital
goods contributes most to low investment in developing countries. Cook recommended that the
authors empirically test their explanation based
on trade barriers against an explanation based on
high investment cost.
Session Two:
Trade, Offshoring and Wage Inequality

The second session featured three papers
on international trade and offshoring and their
implications on wage inequality. Heiwai Tang, an
assistant professor of economics at Johns Hopkins
University, presented “Learning to Export from
Neighbors,” coauthored with Ana Fernandes, a
lecturer in economics at the University of Exeter.
Tang and Fernandes noticed that uncertainty
in the exporting business is large and self-experimentation is costly. Based on the belief that

Globalization and Monetary Policy Institute 2014 Annual Report • FEDERAL RESERVE BANK OF DALLAS 27

exporters gain knowledge about foreign demand
from their neighbors, the researchers developed
a statistical decision model to examine how
learning shapes new exporters’ dynamics and
performance.
Using transaction-level data of all Chinese
exporters, Tang and Fernandes studied how
learning from neighbors affects new exporters’
entry decisions, initial sales, survival rates and
post-entry growth. The authors found that a firm’s
export entry decision and post-entry performance
depend on several key factors predicted by their
learning-from-neighbor model. For instance, the
neighbors’ export performance may serve as a signal when a firm makes its exporting decision. Tang
and Fernandes document that a larger number of
neighbor signals leads to more firm entries and
better post-entry performance.
The paper was discussed by Tuan Luong, an
assistant professor of economics at SHUFE. Luong
noticed that there are two types of signals in
Tang and Fernandes’ model and noise from these
signals independently appears. Luong suggested
the authors consider a case with correlated noise
in which the model will become more general but
remain tractable.
The session’s second paper, “Offshoring
and Wage Inequality: Theory and Evidence from
China,” was presented by Liugang Sheng, an assistant professor of economics at Chinese University
of Hong Kong. The paper’s coauthor is Denis Tao
Yang, a professor at the Darden School of Business
at the University of Virginia. Trade in intermediate
goods accounts for a large proportion of international trade. Sheng and Yang examine the effect
of two forms of intermediate-goods trade—offshoring and arm’s length transactions—on wage
inequality. The authors argue that foreign direct
investment (FDI) offshoring is more skill intensive
than arm’s length transactions and, thus, has a
greater effect on upgrading skills in FDI-recipient
developing countries.
Sheng and Yang tested their theory with
China’s data when it removed foreign ownership
restrictions prior to membership in the World
Trade Organization in 2001. Following the policy
change, wholly foreign-owned firms began playing a more important role than joint ventures
in China’s FDI inflows and exports. The authors

found that increases in FDI offshoring significantly
contributed to a greater wage premium for college
graduates after 2001.
Zhiyuan Li, an associate professor of economics at SHUFE, discussed the paper, noting
that it remains puzzling that the wage premium
of college graduates increased among wholly
foreign-owned firms, but not with joint ventures,
if both types of FDI offshoring are skill intensive.
Li proposed that processing trade may be the answer. In processing trade, firms import all or part
of their inputs to produce final goods that will be
exported to foreign countries. It is well-documented that processing trade is usually labor intensive
and requires few skills. The situation the authors
document is consistent with the reality that
joint ventures mainly focus on processing trade,
while wholly foreign-owned FDI firms do not. Li
recommended that the authors take into account
processing trade in their theoretical model and
empirical exercises.
Bo Chen, an associate professor of economics at SHUFE, presented the session’s last paper,
“Wage Inequality and Input Trade Liberalization:
Firm-Level Evidence from China,” coauthored
with Miaojie Yu, a professor of economics at
Beijing University, and Zhihao Yu, a professor of
economics at Carleton University. Chen, Yu and
Yu studied the effect of input tariff reductions
on wage inequality within a firm. Using Chinese
firm-level data, the authors found that input tariff
reductions widened within-firm wage inequality
because high-skill labor enjoys a larger proportion
of the incremental profit than low-skill labor.
Yifan Zhang, an associate professor of
economics at Lingnan University, discussed the
paper, arguing that the profit increase following a
tariff reduction is unrelated to worker productivity.
Thus, it is unclear whether skilled labor will enjoy
a larger share of additional profit than unskilled labor. He suggested the authors also consider other
factors, such as bargaining power, in their tests.
Session Three:
Trade Policy, Offshoring and FDI

The last conference session featured papers
on international market access, tariff reduction
and international organization of production. Emily Blanchard, an assistant professor of business

It remains puzzling
that the wage
premium of college
graduates increased
among wholly
foreign-owned
firms, but not with
joint ventures, if
both types of FDI
offshoring are skill
intensive.

28 FEDERAL RESERVE BANK OF DALLAS • Globalization and Monetary Policy Institute 2014 Annual Report

If a foreign country
exports intermediate
inputs to China that
are then used to
produce final export
goods sold to the
same foreign country,
the foreign country
may have a strong
incentive to reduce
tariffs on China’s
finished goods.

administration at Dartmouth College, presented
“U.S. Multinationals and Preferential Market Access,” coauthored with Xenia Matschke, a professor of economics at Universität Trier.
Blanchard and Matschke examined the
relation between U.S. multinational companies’
offshoring and U.S. preferential trade agreements,
using data covering 84 industries and 184 U.S.
trading partners over 10 years. The authors found
that industries and countries with greater U.S.
foreign affiliate exports to the U.S. enjoy more preferential duty-free access to the U.S. The findings
hold even after controlling for the endogeneity
issue of U.S. multinational companies’ choice of
offshoring activity, suggesting that the pattern of
international investment by U.S. firms may play a
key role in shaping U.S. trade policy preferences.
Wei-Chih Chen, an assistant professor of economics at SHUFE, commented on the paper, noting that the authors may want to check the robustness of their empirical findings. Blanchard and
Matschke note that the positive relation between
U.S. foreign affiliate exports and preferential trade
agreements may simply reflect market-seeking
investment by U.S. companies: The multinationals
will invest and sell in countries with preferential
trade agreements with the U.S. To control for
this issue, the authors used U.S. affiliates’ sales
to the local markets as an instrumental variable
that helps identify the causal effect of U.S. foreign
affiliate exports on preferential trade agreements.
Chen argued that U.S. foreign affiliates’ sales to the
rest of the world may also correlate with U.S. preferential trade agreements, and the authors may
also want to consider this factor in their empirical
study.
The second paper, “Technology and Production Fragmentation: Domestic versus Foreign
Sourcing,” was presented by Teresa Fort, an
assistant professor of business administration at
Dartmouth College. Fort empirically investigated
the effect of changes in communication and
information technology (CIT) on firms’ production processes using firm-level data of the U.S.
manufacturing entities. First, it has been shown
that firms using more CIT outsource production
across more locations. Second, Fort provided
causal evidence that CIT lowers the costs of
outsourcing and the effect is stronger for domestic

outsourcing than foreign outsourcing.
Linke Zhu, an assistant professor of economics at SHUFE, discussed the paper. Zhu would like
to see more empirical evidence of the author’s
implicit assumption that the cost of adopting CIT
is mainly a fixed sunk cost.
Zhi Yu, an assistant professor of economics
at SHUFE, presented “Input Export Promotion
and Output Tariff Reduction,” coauthored with
Rodney Ludema and Anna Maria Mayda, associate professors of economics at Georgetown
University, and Miaojie Yu, a professor of economics at Beijing University. The authors, drawing on
Chinese transaction-level trade data, investigate if
the import of intermediate inputs from a foreign
country helps reduce tariffs on home country
exports of final goods to the foreign country. If a
foreign country exports intermediate inputs to
China that are then used to produce final export
goods sold to the same foreign country, the foreign
country may have a strong incentive to reduce
tariffs on China’s finished goods. The tariff reduction will benefit both countries since it encourages
intermediate-goods imports from China.
Discussing the paper, Blanchard pointed out
that the effect of vertical linkages between finalgoods producers and intermediate-goods producers operates through prices. She suggested that, if
the data are available, the authors investigate how
a decrease in the final-goods tariff increases the
price and profits of intermediate-goods producers
in the foreign country.
Current Issues and Future Study

Participants of the 1½-day conference exchanged ideas about understanding international
trade and related macroeconomic issues by using
microlevel data. The discussions shed light on
important current issues and also inspired future
research topics.
First, the microlevel data provide a foundation to study important macro issues, such as
monetary policy, inflation and trade imbalances.
Wang and his coauthors found that exportingfirm behaviors change with exchange rate
policy. Specifically, aggregate price indexes may
underestimate the pass-through of the renminbi
appreciation on U.S. import prices. Hnatkovska
and her coauthors showed that developing and

Globalization and Monetary Policy Institute 2014 Annual Report • FEDERAL RESERVE BANK OF DALLAS 29

advanced economies have different transmission
mechanisms for monetary tightening through its
effects on the exchange rate.
Second, the benefits of international trade
may be underappreciated in trade models based
on aggregate-level data. As Sposi and coauthors
pointed out, international trade plays a much
more important role in economic growth once
trade in capital goods is carefully incorporated in
models as microdata suggest. This line of research
provides microeconomic evidence of the importance of free trade in promoting economic growth.
Third, microlevel data provide information
on how firms engage in international trade and
FDI and the effects of these activities on issues
such as wage inequality. Tang and his coauthor’s
research shed light on how firms learn to export
from their neighbors. Policies that facilitate information sharing may reduce learning costs and
help promote exports. While international trade
and capital flows usually benefit overall economic
growth and reduce cross-country income inequality, trade and capital market liberalization could
induce an increase in income inequality within a
country, which deserves policymakers’ attention.
Sheng and Yang documented that the significant
increase in FDI offshoring after 2001 contributed
to the sharp increase in the wage premium of
college graduates. Chen and coauthors argue
that input tariff reductions may increase wage
inequalities between skilled and unskilled labors
within a firm.
Finally, multinational companies’ offshoring
and trade activities shaped the trade policy in the
home country. Blanchard and her coauthor found
that industries and countries that have more U.S.
foreign affiliate exports to the U.S. receive more
preferential duty-free access to the U.S. Yu and coauthors document that China faces a lower tariff
on final exports to a foreign country if that country
exports to China more intermediate inputs used in
final export production.

While international trade and
capital flows usually benefit overall
economic growth and reduce crosscountry income inequality, trade
and capital market liberalization
could induce an increase in income
inequality within a country, which
deserves policymakers’ attention.

30 FEDERAL RESERVE BANK OF DALLAS • Globalization and Monetary Policy Institute 2014 Annual Report

The Political Economy of International
Money: Common Currencies, Currency Wars
and Exorbitant Privilege
By J. Scott Davis

and Mark A. Wynne

2014 Conference Summary
When: April 3–4
Where: Southern Methodist University
Dallas, Texas
Sponsors: Owens Foundation and the
Federal Reserve Bank of Dallas’ Globalization and
Monetary Policy Institute

he Political Economy of International
Money: Common Currencies, Currency Wars and Exorbitant Privilege”
conference was held at the John
Goodwin Tower Center at Southern Methodist University on April 3–4. It was sponsored by the Owens
Foundation and the Federal Reserve Bank of Dallas’
Globalization and Monetary Policy Institute.
Kathleen Cooper of the Tower Center, SMU
economics professor Thomas Osang, and Mark A.
Wynne and Jian Wang of the Dallas Fed organized
the conference, the third such gathering in which
the Dallas Fed participated along with the Tower
Center and the Owens Foundation. The first two, in
2010 and 2012, were immigration related.1
The importance of international economic
forces has increased significantly over the past
three decades with the opening of China, the
collapse of the Soviet bloc and liberalization of the
Indian economy. The net effect of these developments has been to add about 3 billion consumers
and producers to the global economy.
The extraordinary growth rates that some
emerging-market economies have realized over the
period meant that in 2007, for the first time, more
economic activity occurred in emerging-market
and developing economies than in the advanced
economies, according to International Monetary
Fund (IMF) estimates (Chart 1).2
The center of gravity of global economic activity is shifting inexorably from the North Atlantic to
East Asia. By some estimates, China’s economy is
already as big as that of the United States.
The term “globalization” has been used to
describe these changes. While some have tended to
dismiss the expression as faddish, it remains useful
shorthand. Of course globalization is not new.
Students of history are familiar with the first era of
globalization, prior to World War I. Then, interna-

tional monetary relations were governed by the
widespread adherence to a commodity standard,
and central banks played a role very different from
what they do today. But goods, capital and people
flowed across national borders as easily as now.
This year’s conference examined a very different aspect of globalization. When planning for it
began, the euro crisis was headline news. Financial
globalization has remade the world in ways that few
could have anticipated when the first steps were
taken toward liberalizing capital flows four decades
ago. It is fair to say that in the absence of international capital flows, the housing boom in the United
States would have ended sooner and probably with
less dire consequences than those the nation has
confronted since 2008.
Likewise, it seems reasonable that housing
booms in Ireland and Spain would have been less
dramatic absent the cross-border lending facilitated
by a common currency. The policy response to the
financial crisis had an important international dimension that was unprecedented—from coordinated interest rate cuts in October 2008 to the creation
of international currency swap lines that have since
become semipermanent.
Advanced economies’ highly accommodative
actions led to claims that the Fed and other central
banks were engaging in a currency war against
emerging markets. When talk began in 2013 of
tapering Fed asset purchases under quantitative
easing, the central bank was again criticized for pursuing policies perceived as adversely affecting other
countries. Thus, an examination of the economic
and political economy dimensions of financial
globalization seemed timely, and the conference
brought together top scholars.
Improving Policy Coordination

Jeffry Frieden, a professor of government at

Globalization and Monetary Policy Institute 2014 Annual Report • FEDERAL RESERVE BANK OF DALLAS 31

Harvard University, addressed international cooperation in economic policy in his keynote remarks,
characterizing proposals to improve the exchange
of ideas as ranging from cynical to utopian. The
recent financial crisis elicited an unprecedented
degree of cooperation between the world’s leading
central banks, though even more frequent cooperation was probably needed. Frieden said he believes
that from a political economy standpoint, greater
policy coordination is likely in the future.
The challenges posed by international capital
flows, especially the procyclical nature of such flows,
are particularly relevant, he said. Previously, only
emerging-market economies confronted this problem, but over the past 15 years advanced economies
have also faced it. Such flows create an externality
warranting a policy response, he said, with the case
for action resembling macroprudential regulation
of the banking system. Just as individual banks
don’t have an incentive to take into account how
their lending activities impact the national financial
system, national regulators don’t have an incentive to
gauge the impact of their actions on the international
financial system. For this reason there is benefit
to policy coordination to monitor and possibly
restrict international capital flows. While nations are
reluctant to surrender sovereignty, delegation of responsibility over some matters, if managed correctly,
may be possible. The European Union provides an
example in this regard.
Ronald McKinnon, an international economics professor at Stanford University, gave the second
keynote address. McKinnon, now deceased, was
one of the fathers of the theory of optimum currency
areas, an idea that when it was proposed seemed farfetched and of theoretical interest at best.3 From the
1960s through the 1990s, few envisioned sovereign
nations agreeing to share a common currency. In
1999, the euro became a reality.
Some of the currency’s recent problems
were anticipated by the contributors to the theory
of optimum currency areas; others, such as the
need for a banking union, were not. McKinnon
wrote on many other issues as well, perhaps most
prolifically in recent years on the global dollar
standard, which he characterized in a 2013 book
as “unloved.”4 Three decades ago, he called for
harmonizing monetary policies among the world’s
leading central banks. He suggested fixing the

trend rate of growth of each country’s monetary
base to provide greater international monetary
system stability.5 And he was an early proponent
of taking a global rather than a domestic perspective on monetary developments to better ensure
price stability.6 Many of the issues with which
McKinnon wrestled during his career remain.
In his remarks, titled “The Unloved World
Dollar Standard: Greenspan-Bernanke Bubbles
in the Global Economy,” McKinnon noted that
the world has long operated on a dollar standard,
with Federal Reserve monetary policy creating
a first-order impact on global financial stability.
Reiterating an observation he first made decades ago, McKinnon said that except at times of
international financial crises, the Fed tends to be
inward looking, focusing on domestic economic
developments and ignoring potential international
collateral damage from its monetary policies. In
McKinnon’s view, this makes the U.S. economy less
stable. Since fall 2008, ultra-low interest rates on
dollar assets have propelled waves of money into
emerging markets by investors engaging in carry
trades, which exploit differences in borrowing costs
between nations. These investments have generated bubbles in international primary commodity
prices and other assets. Quite apart from the detrimental effects that ultra-low interest rates in the

The recent financial
crisis elicited an
unprecedented
degree of
cooperation between
the world’s leading
central banks, though
even more frequent
cooperation was
probably needed.

Chart 1
Emerging-Market Share of World Output Passes 50 Percent
Share of world GDP (at purchasing power parity)
65

60
Developed economies

Emerging markets

35
1992

1994

1996

1998

2000

SOURCE: International Monetary Fund.

2002

2004

2006

2008

2010

2012

2014

32 FEDERAL RESERVE BANK OF DALLAS • Globalization and Monetary Policy Institute 2014 Annual Report

U.S. have on the rest of the world, near-zero interest
rates also hold back investment in the American
economy.7
Many of the issues that McKinnon raised in
his opening remarks are addressed at greater length
in his book, The Unloved Dollar Standard: From
Bretton Woods to the Rise of China. Following his
presentation, audience members questioned some
elements of his thesis, such as how low interest rates
might simultaneously boost commodity prices and
not stimulate demand in advanced economies,
or how a policy of low short-term interest rates
detracted from the ability of banks to lend profitably.
Volatility of Flows
Professor Ronald McKinnon of Stanford University

Globalization is about international capital
flows first and foremost, and the first panel addressed this issue from several different angles.
The scale of U.S. capital outflows has exploded in
the past few decades. The volatility of these capital
flows during the recent financial crisis was unprecedented (Chart 2).
The first panelist, Carol Bertaut, the chief of
the Global Financial Flows Section of the Federal
Reserve System Board of Governors, built on issues
McKinnon raised in his address, specifically the
character and determinants of “hot money” flows

Chart 2
U.S. Capital Outflows Exhibit Volatility, U.S. Foreign Direct
Investment Remains Steady
Billions of dollars
800
Total outflows
600

Foreign direct investment outflows

400

200

–200

–400
’81 ’83

’85 ’87 ’89

’91 ’93 ’95 ’97

SOURCE: International Monetary Fund.

’99 ’01 ’03 ’05 ’07 ’09 ’11

’13

into emerging markets. As indicated in Chart 2,
while U.S. long-term foreign direct investment
outflows are fairly steady, the volatility in capital
outflows in the past few years has been due to
fluctuations in short-term, hot money flows. Bertaut
sought to determine whether a “reach for yield” or
possibly some other motivation drove these flows.
She found that most U.S. investment in foreign
bonds is in high-quality assets. While the share of
U.S. investment into riskier emerging-market bonds
rose in recent years, its 15 percent share of the
total U.S. foreign bond portfolio remains small. A
“search for safety,” not the “reach for yield,” remains
the main driving factor behind U.S. investment in
foreign bonds, Bertaut said, citing evidence that
the trend is mainly driven by investment into highgrade financial corporate bonds. There is limited
evidence that the reach for yield has driven U.S.
investment in foreign government bonds since the
global financial crisis in 2008.
Michael Klein, a professor of international
economic affairs at Tufts University, opened his
presentation with two quotes from John Maynard
Keynes. The first was an oft-repeated excerpt
from The Economic Consequences of the Peace,
highlighting just how easy it was for an investor
in pre-WWI London to “adventure his wealth in
the natural resources and new enterprises of any
quarter of the world, and share, without exertion
or even trouble, in their prospective fruits and advantages.” The second was a less-well-known quote
from Keynes’ inaugural Finlay Lecture at University College Dublin in 1933: “I sympathize … with
those who would minimize rather than those who
would maximize economic entanglements among
nations. … Let goods be home-spun whenever it is
reasonable and conveniently possible and, above
all, let finance be national.”8
Klein used the quotes to open a discussion of
how conventional wisdom regarding the desirability of controls on international capital flows has
shifted, especially following the global financial crisis. Klein drew a distinction between controls that
he characterized as “gates” (designed to regulate
flows) and those he viewed as “walls” (designed to
prevent flows). Too often, discussion of the desirability of gate-like controls was confused by likening
them to wall-like controls, Klein said.
Gates have their problems (they may not shut

Globalization and Monetary Policy Institute 2014 Annual Report • FEDERAL RESERVE BANK OF DALLAS 33

tightly, they may shut too late and they may have
rusty hinges), but they may sometimes be employed
usefully to support monetary autonomy and for
macroprudential purposes. However, data on the experiences of Brazil and Korea, with gate-like controls
in recent years, seem to suggest that they were of
limited effectiveness unless broad based, he said.9
The third panelist, Frank Warnock, professor of business administration at the University of
Virginia’s Darden School (and also a senior fellow
at the Globalization and Monetary Policy Institute),
argued for more careful language when discussing
capital flows, noting that they come in many forms
and can be due to portfolio reallocation and portfolio growth.
Even after controlling for portfolio growth,
it is important to distinguish between active and
passive reallocation due to exchange rate changes,
for example. These distinctions are important when
assessing whether U.S. investors are underweight
in foreign securities. U.S. investors appear to be
becoming more underweight in emerging markets,
investing less in these markets than simple benchmark models would suggest, Warnock said.
Discussions of global capital flows, especially over the past decade and a half, are often
conditioned by what former Fed Chairman Ben
Bernanke characterized as a global saving glut.10 In
the discussion that followed the session, audience
members asked whether the real problem associated with international capital flows prior to the crisis was a global banking glut as opposed to a global
saving glut, as South Korean financial economist
Hyun Shin has argued.11
Shared Monetary Challenges

In the euro area, the sharing of the common
currency amplifies the challenges international
capital flows cause. Rutgers University economics
professor Michael Bordo, a senior fellow of the Globalization and Monetary Policy Institute, opened
the second panel on common currencies, asking
whether the euro will survive.
He cited work with Lars Jonung that showed
national monetary unions tend to work better
than international unions. The euro crisis exposed
flaws in the design of the single currency, he said.
Moreover, the crisis response has been troubled.
Bordo argued that the IMF and other members

of the so-called troika—the IMF, the European
Central Bank (ECB) and the European Commission—would have done better by allowing Greece
to default rather than restructuring its sovereign
debt. In its crisis response, the ECB engaged in fiscal policy and exposed itself to credit risk. The euro’s
prospects for a crisis-free future are limited, though
it will likely survive as long as there is political will,
Bordo said.
The architects of European Economic and
Monetary Union were aware of the difficulties that
arise when a diverse group of countries share a
common currency. To that end, they installed an
institutional framework, the Maastricht Treaty. What
few seemed to appreciate prior to the launch of the
single currency in 1999 was the need for a banking
regulatory union to accompany monetary union.
The absence of such oversight was key to crises in
Ireland and Spain. (The crisis in Greece was due to a
failure to follow Maastricht Treaty guidelines.)
Hubert Kempf, an economics professor at
ENS Cachan in Paris, examined the progress toward
building a banking union in the euro area. Only a
partial banking union, covering the single market
and the TARGET2 payments system, exists, he said.
Other aspects of a full union—a single set of regulations, bank supervisor, resolution mechanism and
deposit insurance protection—are missing. While
there has been progress, problems remain related to
risk sharing and ceding of national sovereignty.
David Malpass, president of Encima Global, a
New York economic research and consulting firm,
examined changes in balance sheets of the Federal
Reserve and the ECB as a result of their responses
to the financial crises. Despite Fed balance sheet
growth, the U.S. central bank faces less risk than the
ECB. At the time of the conference, the ECB had
not engaged in a quantitative easing (QE) program
comparable to what the Fed began in 2008. A challenge to ECB efforts could be European asset-backed
(mortgage) securities, which differ greatly from
such debt in the U.S. In Europe, almost all mortgages
are floating rate rather than fixed rate. Further, if a
QE type program is to succeed in the euro area, it
must work through the banking system rather than
through portfolio rebalancing, as in the U.S.
In the subsequent question-and-answer
session, audience members asked about renationalization of the euro-area banking system postcrisis.

The architects of
European Economic
and Monetary Union
were aware of the
difficulties that arise
when a diverse group
of countries share a
common currency.

34 FEDERAL RESERVE BANK OF DALLAS • Globalization and Monetary Policy Institute 2014 Annual Report

China’s surplus
with the rest of the
world and the U.S.
has declined by a
substantial amount
in recent years, due
in no small part to
appreciation of the
renminbi.

Banks that were active in cross-border lending before the crisis seem to have retreated to their home
markets. This might weaken the case for a robust
euro-area banking union. Others inquired about
the new fiscal compact designed to provide a more
rigorous framework for responsible management of
public finances in the euro area, and whether it can
be viewed as a meaningful step toward fiscal union.
Still others questioned whether the fiscal compact will prove any more binding than the Stability
and Growth Pact that it replaces. One presenter
noted that real progress toward the creation of a fiscal union will necessitate the creation of a transfer
union and the issuance of a euro bond, neither of
which seem likely imminently.
Jeffrey Frankel, professor of capital formation
and growth at Harvard University’s Kennedy School,
presented the third and final keynote speech.
Frankel’s presentation ranged over a variety of issues
that arose during conference discussions. Frankel,
responding to McKinnon’s argument that U.S.
monetary policy lies at the heart of the global dollar
standard, said that targeting nominal gross domestic
product would be superior to the current practice
of a formal inflation target (or numerical price
objective) and informal employment target. In the international arena, he argued that providing emerging
market economies a greater say in the management
of the global economy is long overdue.
The creation of the Group of 20 (as an alternative to the G7) is an important step, but others
are needed, for example, altering the distribution
of votes in international institutions such as the
IMF, Frankel said. He also proposed an unorthodox
solution to problems facing the Fed and the ECB.
The Fed is holding large quantities of U.S. Treasuries
that it will need to dispose of at some point, while
the ECB needs to boost activity in the euro area, or
at a minimum prevent an entrenched Japan-style
deflation. An ECB purchase of the Treasuries could
remedy both problems, Frankel said. This would
allow the Fed to dispose of its holdings of Treasuries while allowing the ECB to add liquidity without
violating the Maastricht Treaty prohibition of
monetary financing.

assistant secretary for international economic
analysis at the U.S. Treasury Department, opened by
suggesting that martial language (such as references
to currency wars) doesn’t aid resolution of these
issues. Such talk is probably better suited to the
19th century than to contemporary international
relations, Setser said. He noted that significant
progress has been made in eliminating international
imbalances, though more needs to be done.
China’s surplus with the rest of the world and
the U.S. has declined by a substantial amount in
recent years, due in no small part to appreciation of
the renminbi, he said. Additionally, the IMF entered
the financial crisis with fewer resources than
some emerging-market economies hold in foreign
exchange reserves. Even after a recent increase in
the resources available to the IMF, it still falls short
of what the best-resourced emerging-market economies have at their disposal, Setser said. Finally, Setser addressed the issue of adverse spillovers from
U.S. monetary policy to the rest of the world, noting
that the world generally benefits from U.S. demand
expansion.
Benjamin Cohen, professor of international
political economy at the University of California
at Santa Barbara, discussed attempts to manage
exchange rates between the world’s currencies.
He argued that the notion of currency wars had its
origins in the experiences of countries with floating
exchange rates during the 1930s. This shared experience prompted the post-World War II consensus
in favor of managed exchange rates. However,
such attempts have not proven effective because
national governments have been reluctant to cede
authority to supranational institutions such as the
IMF. Dirty floats are prevalent, and talk of currency
wars is not exaggerated, he said.
Conflicts about currency values are ultimately
conflicts about trade, and specifically about countries seeking to gain an unfair advantage for their
exporters internationally. Lawrence Broz, a political
science professor at the University of California at
San Diego, examined the interaction between real
exchange rate appreciation (that is, exchange rate
appreciation correcting for differences in price
levels) and calls for trade protection in the United
Assessing Currency Wars
States. Such demands in the U.S. increased signifiThe final session of the conference was devoted cantly in the first half of the 1980s as the real value
to a discussion of currency wars. Brad Setser, deputy of the dollar soared (especially against Japan) and

Globalization and Monetary Policy Institute 2014 Annual Report • FEDERAL RESERVE BANK OF DALLAS 35

again in the 2000s as the value of the renminbi was
prevented from gaining against the dollar.
Yet movements in real exchange rates have
very different effects at the level of individual industries and sectors. The extent to which exchange rate
movements pass through to final goods prices will
influence how strongly an industry or sector will
lobby for trade protection. Commodity producers
with limited pricing power will tend to be more sensitive to exchange rate movement, while companies
with extensive global supply chains that import a lot
of their inputs will be less sensitive.
Benn Steil, a senior fellow at the Council
on Foreign Relations, offered the conference’s
last formal presentation. He focused on how Fed
policy impacts emerging markets, opening with a
hypothesis about the impact of tapering on political
developments in Ukraine: The Fed’s reduction of
bond purchases pushed up interest rates and reduced financing available to many emerging-market economies; in Ukraine this lack of foreign funds
drove then-President Viktor Yanukovych to seek
support from Moscow, igniting protests in late 2013
that sparked the crisis.
Transcripts of Federal Open Market Committee (FOMC) meetings held during 2008 were
released in early 2013, and Steil called attention to
the discussion of extending U.S. dollar swap lines
to emerging-market economies. Not all countries
requesting such swap lines received them. Rather,
priority was given to those countries perceived as
posing systemic risk to the U.S. financial system if
forced to liquidate their holdings of dollar-denominated securities to meet liquidity needs. Thus, Fed
policy in deciding which countries would receive
swap lines directly impacted financial conditions
in emerging markets by determining availability of
dollar-denominated liquidity.
‘Exorbitant Privilege’

The conference ended with a question posed
by an audience member echoing the title of the
conference: “Is exorbitant privilege intact?” This
question effectively summarizes much of what was
discussed. Among the conclusions, the dollar’s position as the international reserve currency is safe,
largely because there are no obvious candidates
to take its place, and the euro is beset by serious
structural flaws requiring resolution before it can be

Conference presenters

anything more than a regional currency. The renminbi is not freely traded, and capital control “walls”
in China will continue preventing any internationalization of the currency. Increasing financial integration will mean that the U.S. economy becomes
ever more entangled with the economies in the rest
of the world, and the dollar’s position as the world’s
reserve currency means that U.S. monetary policy
and the actions of the Fed will continue affecting
economic conditions far beyond U.S. borders.
Notes
1
The Owens Foundation was established by the widow of
John E. Owens in memory of her husband, a prominent
Texas banker. During his lifetime, Mr. Owens was intensely
interested in international relations and he sought to
establish a foundation that would memorialize this interest.
The broad objective of the conferences sponsored by the
Owens Foundation is to deepen public understanding of
international economic forces in the philosophical context
of free trade.
2
Developed economies refers to the IMF classification of
advanced economies and includes the Group of 7 countries:
the U.S., the U.K., Japan, France, Italy, Germany and
Canada. Emerging markets refers to the IMF classification
of emerging markets and developing countries and includes
BRICS countries: Brazil, Russia, India, China and South
Africa.
3
See “Optimum Currency Areas,” by Ronald I. McKinnon, American Economic Review, vol. 53, no. 4, 1963, pp.
717–25.

4
See The Unloved Dollar Standard: From Bretton Woods
to the Rise of China, by Ronald I. McKinnon, Oxford, U.K.:
Oxford University Press, 2013.
5
See “Why U.S. Monetary Policy Should Be Internationalized,” by Ronald I. McKinnon, in To Promote Peace: U.S.
Foreign Policy in the Mid-1980s, Dennis Bark, ed., Palo Alto,
Calif.: Hoover Press, 1984, pp. 57–68.
6
See “Currency Substitution and Instability in the World
Dollar Standard,” by Ronald I. McKinnon, American Economic Review, vol. 72, no. 3, 1982, pp. 320–33.
7
McKinnon argued that ultra-low interest rates in the
U.S. encourage large U.S. corporations to turn to financial
markets instead of banks for financing. The loss of some of
their larger and safer customers makes the balance sheets
of many smaller banks riskier, so they may be forced to cut
their overall loan portfolio, including reducing lending to
many small and medium-sized corporations that cannot turn
to financial markets for financing.
8
See “National Self-Sufficiency,” by John Maynard Keynes,
Studies: An Irish Quarterly Review, vol. 22, no. 86, 1933,
pp. 177–93.
9
See also Klein’s VoxEU article “Capital Controls: Gates
versus Walls,” Jan. 17, 2013, www.voxeu.org/article/
capital-controls-gates-versus-walls.
10
See “The Global Saving Glut and the U.S. Current Account
Deficit,” speech by Ben Bernanke at the Sandridge Lecture,
Virginia Association of Economists, Richmond, Va., March
10, 2005.
11
See “Global Banking Glut and Loan Risk Premium,” by
Hyun Song Shin, paper presented at the 12th Jacques Polak
Annual Research Conference, International Monetary Fund,
Washington, D.C., Nov. 10–11, 2011.

36 FEDERAL RESERVE BANK OF DALLAS • Globalization and Monetary Policy Institute 2014 Annual Report

The Federal Reserve’s Role in the Global
Economy: A Historical Perspective
By Michael Weiss

2014 Conference Summary
When: Sept. 18–19
Where: Federal Reserve Bank of Dallas
Sponsor: Federal Reserve Bank of Dallas’

he Globalization and Monetary
Policy Institute at the Federal Reserve
Bank of Dallas sponsored the Bank’s
centennial conference analyzing the
evolution of the U.S. central bank, from its beginnings 100 years ago to its future influencing global
monetary policy. The gathering, held Sept. 18–19
at the Dallas Fed, included the inaugural Robert V.
Roosa Memorial Lecture, a conversation with former Federal Reserve Chairman Paul A. Volcker. The
conference was organized by Dallas Fed Vice President and Globalization Institute Director Mark A.
Wynne and institute senior fellow Michael D. Bordo,
a professor of economics at Rutgers University.
The conference program was divided into
three sessions: “Beginnings: The Gold Standard,
Global Conflict and the Great Depression,” “Coming
of Age: From Bretton Woods to the Great Inflation
to the Great Moderation” and “Globalization 2.0:
Monetary Policy in a Global Context: Past, Present
and Future.”
The first session featured two presentations.
Barry Eichengreen, professor of economics and
political science at the University of California,
Berkeley, began his discussion of “Doctrinal
Determinants, Domestic and International, of
Federal Reserve Policy, 1914–1933” by arguing that
international considerations made up only a part of
the factors—though not negligible—intermittently
shaping the Federal Reserve’s outlook and policies
during an initial era that ended in 1933.

Globalization and Monetary Policy Institute
Monetary Policy Doctrines

Eichengreen said the period was characterized
by a series of doctrines. The Gold Standard Doctrine
predominated at the time the Federal Reserve System was created. Gold inflows and outflows often
signaled changes in central bank policy. Still, there
wasn’t a rigid rule. Rather, the gold standard was not

just a statutory requirement but also a way of thinking. “The gold standard was not a mechanical set
of rules,” Eichengreen said. The Real Bills Doctrine,
mirroring central bank thinking of the late 19th and
early 20th centuries, stressed the notion that the
central bank should provide an “elastic currency”—
as much money and credit as needed for business
purposes (as opposed to speculative ones).
The Reifler–Burgess Doctrine, which followed,
closely resembled Real Bills and proposed that the
Federal Reserve had “multiple instruments to intervene.” Reifler-Burgess, however, concluded that the
level of interest rates—whether achieved through
discount-window borrowing or open market operations—was the only adequate way to summarize the
stance of monetary policy. The subsequent Warburg
Doctrine, named for German-American banker Paul
Warburg, accompanied the U.S.’s ascension as an
emerging market of the 20th century. The doctrine,
which carried “a distinctive foreign policy element,”
sought to “enhance the international role of the
dollar” as a means of promoting U.S. economic competitiveness. Warburg, a Fed Board member at the
institution’s 1914 founding, argued that the central
bank as a market maker for trade acceptances could
regulate interest rate movements. The Warburg
Doctrine, however, was ill-equipped to deal with the
integration of monetary and fiscal policy, Eichengreen said.
The Strong Doctrine, named after Federal Reserve Bank of New York Governor Benjamin Strong,
countered the Real Bills Doctrine, suggesting that
rather than interest rates, the central bank should
focus on money and credit aggregates. Strong, an
ally of Bank of England Governor Montagu Norman
and a pragmatist, “believed in discretionary policy”
absent specific rules and thought stable exchange
rates encouraged U.S. commodity exports. The subsequent Harrison Doctrine represented a tempera-

Globalization and Monetary Policy Institute 2014 Annual Report • FEDERAL RESERVE BANK OF DALLAS 37

mental rather than a doctrinal departure: George
Harrison served as Strong’s deputy for almost nine
years before taking over at the New York Fed.

title of the U.S. central bank has in its essence “a distinctly foreign and security dimension to it,” James
said. Warburg makes frequent analogies to armies
and defense.

Greater Fed Latitude

The Glass–Steagall Doctrine epitomized in
the Glass–Steagall Act of 1932 relaxed collateral
requirements on Federal Reserve notes, providing a
bit of distance from the Gold Standard Doctrine, and
allowed a greater range of securities against which
the Fed could lend, thus countering Real Bills. Conceptually, Glass–Steagall provided an incremental
step toward the policies of Franklin Roosevelt and
the Roosevelt Doctrine. A reflationary period in the
wake of the Great Depression, it is characterized as
a time of inconsistent policy and wavering from the
gold standard.
Eichengreen traced the doctrines from the
post-World War I recession through central bank
open market purchases in 1932. Following WWI,
preservation of the gold standard in the U.S. set the
stage for the gold standard’s international restoration. “The dollar was the lynchpin of the international system,” Eichengreen said. During 1924 and 1927,
the U.S. experienced gold inflows, with international
considerations “playing a subsidiary role.” During
the great crash and its aftermath, 1929–30, the Fed
loosened and provided emergency liquidity but subsequently, in accordance with the interest-rate-driven Reifler–Burgess Doctrine, mistakenly believed
its work was over in 1931 and tightened monetary
policy in the first of “its critical errors.” The Fed, amid
congressional pressure as unemployment exceeded
20 percent, engaged in expansionary open market
operations in April to August 1932, even as the gold
reserve ratio of the New York Fed declined to nearly
50 percent at the end of June 1932. Some have suggested that the Fed retreated in July because of the
possibility of a gold standard crisis.
Discussant Harold James, a Princeton University professor of history and international affairs,
noted that the Paul Warburg Doctrine sought to
define the Federal Reserve along the lines of foreign
central banks of the period. Warburg’s brother, with
whom he was in regular contact, was an adviser
to Kaiser Wilhelm II and was working to reform
the German financial system. So in essence, the
Warburg approach was being applied in two places
simultaneously. The use of the word “reserves” in the

Absence of International, Political
Pressure

The session’s second paper, “Navigating Constraints: The Evolution of Federal Reserve Monetary
Policy, 1935–1959,” examined Federal Reserve
policy during the 1950s, when the central bank’s
efforts appeared effective, and how the Fed evolved
following the disastrous Depression era. The paper,
written by David C. Wheelock, deputy director of
research at the Federal Reserve Bank of St. Louis,
and Mark A. Carlson, a senior economist at the
Board of Governors of the Federal Reserve System,
was presented by Wheelock.
The paper proposed that a significant portion
of the Fed’s success in the 1950s owed to the absence of political and international pressures of the
prior periods. The Fed of the 1950s didn’t confront
policy limitations of the 1930s, when gold inflows
inhibited its open market operations, and the 1940s,
when the central bank was called upon to maintain
low interest rates for Treasury debt amid World War
II. After the war, the Fed sought to control inflation

After World
War II, the Fed
sought to control
inflation while still
maintaining low
interest rates.

Richard Fisher, Guillermo Ortiz and John Taylor

38 FEDERAL RESERVE BANK OF DALLAS • Globalization and Monetary Policy Institute 2014 Annual Report

The Fed’s focus
on the real U.S.
economy and
unemployment while
viewing balance of
payments objectives
as a lesser concern
represented the
shift that assigned
the U.S. Treasury
greater responsibility
for managing
international affairs.

while still maintaining low interest rates. Two 1930s
reforms were significant to later events—the Gold
Reserve Act of 1934, allowing the Treasury to intervene in gold and foreign exchange markets, and the
Banking Act of 1935, providing the Federal Reserve
Board of Governors greater powers relative to the
regional Fed Banks and reconstituting the Federal
Open Market Committee to seven governors and
five Reserve Bank presidents.
Drawing on a statistical analysis of expected
measures of inflation and the output gap (the
difference between the economy’s actual output
and its capacity), the authors concluded that the
Fed responded to macroeconomic conditions by
adjusting the reserves they required banks to hold
beginning in the mid-1930s—increasing reserve
requirements to damp credit availability. Fed policy
was constrained through WWII and in the immediate postwar years by a need to keep interest rates
low in support of Treasury funding operations. The
Defense Production Act in 1950 provided the Fed
powers to directly regulate consumer and real estate
credit markets and influence lending activity.
In March 1951, the Fed and Treasury reached
an agreement freeing the Fed of the responsibility to
limit government debt yields, which could become
more responsive to market forces. Changes in
reserve requirements remained a basic Fed tool of
monetary policy in the 1950s even as gold outflows
drained $1.5 billion in reserves from the banking
system during the first half of 1958 and the balance
of payments deficit reached $4 billion in 1959. Political pressures re-emerged in the 1960s, marking an
end of a decade in which enlightened policymakers
and a stable environment produced “one of the Fed’s
better decades.”
Discussant Gary Richardson, the Federal
Reserve System historian, said Fed inaction during
the 1930s reflected institutional constraints and
legal limitations on open market intervention and
operation of the discount lending window through
which banks could borrow funds. Additionally, the
presence of the gold standard carried intellectual
limits on actions the Fed was willing to take.
Bretton Woods and the Dollar Peg

The conference’s second session, “Coming of
Age: From Bretton Woods to the Great Inflation to
the Great Moderation,” picked up the Fed timeline

with the 1944 Bretton Woods Agreement of managed exchange rates and continued to the period of
relative business-cycle tranquility of the mid-1990s.
The session’s first paper was “Federal Reserve Policy
and Bretton Woods,” by Bordo and Owen Humpage,
a senior economic advisor at the Federal Reserve
Bank of Cleveland. Bretton Woods sought to install
a currency adjustment system that would avoid the
problems of the 1920s, Bordo said. However, just
as the agreement was becoming fully operational,
dollar convertibility concerns weighed on U.S. actions, forcing policymakers to sometimes reluctantly
consider global implications of U.S. economic policy
as the dollar became the key international reserve
currency. At the same time, some abroad resented
what was viewed as the dollar’s “privileged” standing.
The dollar initially was pegged to gold at $35 per
ounce, with developed nations’ currencies pegged to
the dollar.
The Fed’s focus on the real U.S. economy and
unemployment while viewing balance of payments
objectives as a lesser concern represented the shift
that assigned the U.S. Treasury greater responsibility for managing international affairs. It also had the
consequence of eliminating the constraint of foreign
policy on domestic inflation, ultimately dooming
Bretton Woods, Bordo said.
By 1960, total external dollar liabilities exceeded gold holdings, Humpage said. They rose by $5.5
billion in 1960 and by $55.4 billion from December
1969 to March 1973—indicative of the so-called Triffin dilemma (named after Belgian economist Robert
Triffin) of rising international demand for dollars enabling large U.S. current account deficits. Amid U.S.
inflation that remained high relative to modest price
growth before 1965, Bretton Woods unwound from
1971 to 1973, when floating exchange rates replaced
the pegged rates of the Bretton Woods era.
Bordo and Humpage concluded that once
Fed policies after 1960 began focusing on domestic
objectives—employment and maintaining growth—
often at the exclusion of international issues, Bretton
Woods’ days were numbered. Moreover, the removal
of international constraints loosened some of the
restrictions on U.S. monetary policy, setting the stage
for the “Great Inflation,” beginning in the 1970s.
Discussant James Boughton, a senior fellow at
the Center for International Governance Innovation, said he held a more positive view of the Bretton

Globalization and Monetary Policy Institute 2014 Annual Report • FEDERAL RESERVE BANK OF DALLAS 39

Woods era. It paved the way for an era of world
prosperity and relative peace. Its collapse was the
product of internal contradictions and U.S. policy
shortcomings. The system that emerged in the years
after Bretton Woods, rather than relying on a single
economy such as the U.S., assumed prosperity in
multiple countries. The system replaced a single
creditor economy in the world with 17 creditor
economies, many only decades removed from the
devastation of WWII.
Boughton questioned whether Bretton Woods’
demise is lamentable. Inflation became a byproduct
of the Fed’s responsibility to promote employment
(and with it growth). Even in the absence of Bretton
Woods, the U.S. dollar’s global primacy remains.
And finally, he observed, the aftermath of Bretton
Woods hasn’t been as successful as it should’ve
been. Leaders at times have lost sight of the goal of
high employment and growth rates within a broad
framework of monetary and fiscal policy.
In the question-and-answer session, Bordo
said it is unclear whether Bretton Woods was the
reason for successful economic results in the immediate postwar period or if some of the success
represented catch-up from WWII.

foreign exchange markets predominated in the
early years only to decline later. The basic view
loosely linked the dollar to the current account.
The depreciating dollar was widely viewed as an
exogenous source of inflation (aided by rising
commodity prices, especially oil). The early Reagan
administration adopted a “minimalist” approach to
the currency.
As the dollar rebounded following the U.S.
domestic fight against inflation during the Volcker
Fed, it wasn’t until the second half of the Reagan
administration (this time with little Fed involvement) that there was action to ease the dollar’s
value, which gained 45 percent between 1980 and
1985. After peaking in March 1985, it declined by
27 percent amid the Plaza Accord Group of Five
finance ministers’ declaration on Sept. 22, 1985,
that “some further orderly appreciation of the main
non-dollar currencies against the dollar is desirable.”
By the February 1986 Louvre Accord of the Group of
Six countries, the dollar’s depreciation had become
worrisome, prompting agreement to seek stability.
In 1994, Fed Chairman Alan Greenspan, in
collaboration with the Clinton Treasury, decried
a weak dollar as “neither good for the international financial system nor good for the American

economy.” The strong dollar policy of the next 20
years resulted.
The third example of key Fed involvement
was the Great Inflation, belatedly recognized as
a home-grown issue rather than the product of
external forces. Though the ending date of the Great
Inflation is difficult to pin down, it followed Volcker’s
high-interest-rate policies of the early 1980s.
The fourth example was Fed management and
prevention of external financial crises, which tended
to raise the profile of the U.S. central bank. Reflecting the openness of the U.S. economy relative to the
1960s, the 1990s were a period when the Fed went
global. The on-again, off-again Fed participation in
the currency swaps market illustrated policymakers’
ambivalence during the 1990s. With the exception
of arrangements involving Canada and Mexico,
the swaps program was terminated in 1998 as the
European Central Bank (ECB) was beginning operation and the euro came into being. But currency
swaps quickly reappeared in preparation for possible
market disruption in the Y2K millennium computer
transition and then again following the 9/11 terror
attacks. It was most extensively used in support of
global financial stability efforts during the Great
Recession.

Increasing International Stature

Edwin Truman, nonresident senior fellow at
the Peterson Institute for International Economics,
presented his paper “The Federal Reserve Engages
the World (1970–2000): An Insider’s Narrative of
the Transition to Managed Floating and Financial
Turbulence,” which argued that U.S. monetary policy
has come to dominate global monetary policy to a
far greater extent than before. During the last three
decades of the 20th century, the Fed emerged as the
closest thing to a world central bank in an increasingly globalized economic and financial system.
Truman cited four areas where he devoted
particular attention to the Federal Reserve’s role.
First was U.S. external accounts, which predominated in 1970 and by 2000 had eased, only to
reemerge in subsequent years. It was an example of
the global economy’s impact on Federal Reserve actions. Early on, amid the 1973–74 rapid increase of
global oil prices, U.S. international economic policy
was aimed at restoring “a sufficient current account
surplus to support U.S. net private cash outflows.”
Second, Fed attention to the dollar’s value in

Richard Fisher and Paul Volcker

40 FEDERAL RESERVE BANK OF DALLAS • Globalization and Monetary Policy Institute 2014 Annual Report

The challenge for
the Fed is initially
toward domestic
monetary policy
objectives.

Michael Bordo and Harold James

On the broader international stage, the Fed’s
swap lines provided key support to Mexico during its 1994 peso devaluation as the central bank
worked with the Treasury to gain approval of a $40
billion Mexican debt restructuring. The 1997–98
Asian debt crisis brought about a second highprofile intervention. The Fed took on additional
leadership roles during the Russian financial crisis
in 1998 and the collapse of the Long-Term Capital
Management hedge fund.
In all, Fed decision-making or direct intervention was involved 14 times in global interventions
from the 1970s to the start of the new millennium.
The cumulative impact was key to the emergence of
the Fed as the global central bank.
Crisis Illustrates Integrated Markets

A policy panel, “Perspectives of the Fed’s Role
in International Crises,” was the final segment of
session II. Moderated by Dallas Fed President and
CEO Richard Fisher, the panelists were: Donald
Kohn, senior fellow in economic studies at the
Brookings Institution and a member of the Federal
Reserve Board of Governors from 2002 to 2010,
the last four years as vice chairman; Charles Bean,
who retired June 30, 2014, as deputy governor for
monetary policy at the Bank of England; Guillermo
Ortiz, chairman of Grupo Financiero Banorte and
governor of the Banco de México from January
1998 until December 2009; and Stephen Cecchetti,
professor of international economics at the Brandeis
International Business School and former Bank for
International Settlements economic adviser and
head of the Monetary and Economic Department.
The Fed’s central role in the Great Recession
and global financial crisis reflected increasing
international integration of markets and deep dollarasset markets, Kohn said. As the U.S. subprime
mortgage crisis was transmitted around the world,
the U.S. central bank became a primary liquidity
backstop and the crisis manager. The building crisis
was a reflection of outsized spending in the U.S. that
led to extensive borrowing abroad, Kohn said. Foreign banks’ pursuit of presumably “very safe assets”
led to the promotion of mortgage-backed securities
that had received top grades from U.S. credit rating
agencies. The securities conveyed the image of
liquidity, which turned out to be illusory during the
crisis, and spread risk to emerging markets.

Currency swaps between central banks providing liquidity to the global financial system were
part of the crisis response, with 14 countries participating. Once market panic abated, the amount of
the swaps lessened, indicating the correctness of the
central bankers’ response. “Did they work?” Kohn
asked rhetorically. “I think they did.” The emergence
of the swaps raised a boundary problem, namely,
which nations to include, specifically among emerging markets. Within that group, there were three
criteria: 1) participants needed to have significant
financial mass; 2) they required a prudent financial
policy; 3) inclusion in the swaps program would be
of benefit.
In dealing with such a massive financial crisis
in the future, Kohn said, the lack of a lender of last
resort globally could be a problem. The Fed participated in a coordinated rate reduction with the ECB
in October 2008 that sought to bolster confidence
in the banks through their joint efforts. The Fed
has always played a leadership role, Kohn said, as
evidenced by other central banks following the lead
of U.S. policymakers.
Expansionary Policy Benefits All

Bean, reflecting on the international aspects
of Fed crisis efforts, said the Group of 20 (G-20)
finance ministers debated whether advanced
economies had pursued unconventional monetary policies at the expense of emerging markets.
The discussion may have reflected underlying
concerns—specifically, that developed markets
wouldn’t stand behind emerging markets in the face
of instability that could result from withdrawal of the
expansionary policies. Emerging-market financial
leaders, most notably in Brazil, have suggested that
a byproduct of the measures may have been dollar
depreciation as policy was eased and capital flight
as the prospects for normalization increased, Bean
said.
Terming such actions, where they occurred, as
spillover effects, Bean said macroeconomic model
simulations suggest that the crisis management’s
net effect globally was expansionary. “Given that
the world economy was—and still is—suffering
from insufficient aggregate demand, I conclude that
the Fed’s monetary policies were helpful not only
domestically but also for the rest of the world,” Bean
said. Problems lay less with Fed-led actions and

Globalization and Monetary Policy Institute 2014 Annual Report • FEDERAL RESERVE BANK OF DALLAS 41

more with “the unwillingness of some other countries to adjust their policies enough to restore and
rebalance the pattern of global aggregate demand.”
This would include consolidation in some advanced
economies of unsustainable fiscal deficits, structural
market and labor reforms in advanced and emerging markets, and moving the thrust of aggregate
demand toward those countries incurring “chronic
current account surpluses,” Bean said.
The challenge for the Fed is initially toward domestic monetary policy objectives. Only when those
are satisfied can the Fed and the rest of the “central
bank fraternity” turn toward risk mitigation. Those
economies experiencing the side effects of major
central bank policies would best serve their interests
by not only avoiding excessive credit creation and
risk concentration but also by putting “some sand in
the wheels” of the processes that produce excessive
currency inflows and subsequent outflows, Bean
said.
U.S. Policy Spillover into Mexico

Ortiz discussed Fed spillover effects on
Mexico. The U.S. central bank’s initial responsibility is domestic and becomes international to the
extent that broader considerations affect domestic
employment and inflation, Ortiz said. Still, speaking
as a central banker during the last crisis and as the
finance minister during Mexico’s so-called Tequila
Crisis in 1993–94 that included peso devaluation, he
said the Fed must consider the impact of its policies.
Mexico’s gross domestic product (GDP) is highly
correlated with U.S. industrial production. Thus,
capital flows imply that Mexican monetary policy
can’t long deviate from that of the U.S., Ortiz said.
During the Tequila Crisis, Fed currency swaps
helped provide “window dressing” in efforts to
stabilize the peso. The New York Fed established
a trust fund secured by revenues from Mexico’s
state-owned oil company, Petróleos Mexicanos, or
Pemex, and the Fed’s support was crucial for establishment of a stabilization fund.
During the most recent global financial crisis,
Mexico didn’t suffer a “severe financial dislocation,”
Ortiz said. “We made financial stability an objective.”
The Fed, acting as a lender of last resort, was able
to offer a $30 billion currency swaps line, of which
Mexico drew $3.2 billion to bolster liquidity.
Through the two crises, Ortiz pointed to three

tries seeking to draw on the line and could prove
insufficient during a liquidity crisis.
The final option is placing the reinsurance burden with the issuing central bank. In the case of dollar transactions, the Fed would take this responsibility on the assumption that a collapse of the foreign
market for the reserve currency will ultimately harm
the domestic market as well. “That is, the currency
Backstopping the Global
use itself is a globally systemic activity, whose
Financial System
collapse has an effect on everyone,” Cecchetti said.
Cecchetti discussed the dual dollar-based
Moreover, the dollar’s reserve currency role conveys
financial system—international and offshore use
a financing benefit of 0.5 percent of GDP per year,
(accounting for 80 percent of trade finance and 87
providing a benefit for the U.S. to more formally take
percent of currency transactions) versus domestic,
on the reinsurance burden. It would also prompt the
where the U.S. banking system boasts total assets
Fed to act in its “enlightened self-interest” and to provide currency swap lines beyond the five it currently
of $11 trillion. The two came together during the financial crisis when foreign central banks borrowed has established that primarily reflect its domestic
U.S. dollars via the Federal Reserve’s liquidity faciliinterests. (Those lines are with the central banks of
ties—30 countries in all, with borrowing peaking at
Canada, the U.K., Japan and Switzerland and with
$553 billion in December 2008.
the ECB.) Moral hazard issues remain unresolved.
Although the program was a success, especial- Still, the financial crisis underscored the need for a
ly because it came together rapidly during a difficult lender of last resort, and that responsibility falls on
period, it’s worth asking how best to manage risk on the Fed, by virtue of the dollar’s role as a reserve curan ongoing basis, ensuring foreign currency liquidity rency.
without reliance on central banks. Cecchetti suggested five non-mutually exclusive possibilities. One Roosa Lecture: Volcker on Lessons
option, banning intermediaries such as banks from Learned, Future Challenges
Former Fed Chairman Paul Volcker was
offering foreign currency accounts, would be foolish
interviewed by Dallas Fed President Fisher during
and would lead to inventive countermeasures in
the Roosa Lecture, a centerpiece of the two-day
order to maintain trade activities, Cecchetti said. A
second option, making reinsurance the responsibil- conference. Volcker discussed how inflation was
ity of authorities where the activity occurs, would
broken in the early 1980s and the lessons of that
lead to large, expensive reserves, he said, noting
period that can be applied to the most recent crisis
that aggregate foreign exchange reserves total $14
when “a lot went wrong.” The ongoing U.S. balance of
trillion, roughly 20 percent of global GDP. The cost in payments deficit is indicative of “a lack of discipline
loss of real return below the global marginal product in financial markets and in policy” that led “to a
of capital equals roughly 0.2 percent of global GDP
massive financial collapse in the U.S. and elsewhere
each year.
in the world,” Volcker said. An institutional system is
A third option is a regional reinsurance
needed that can provide a “warning signal” of future
through pools of foreign exchange reserves, in
shocks, while supranational organizations such as
the form of multilateral agreements. This has the
the IMF lack the resources to tackle them alone.
benefit of lessening the burden on any one nation’s
Volcker said any rules-based monetary
resources. However, the size of such a fund suggests policy—such as that proposed by conference
that overall reserve requirements wouldn’t signifispeaker and Stanford University economist John
cantly reduce an individual nation’s requirements. A Taylor, linking policy rates to an economy’s output
fourth option, supranational organization involveand inflation—must maintain an active role for
ment, would resemble the IMF’s flexible credit line
central bankers. “I believe we would want to always
created in 2009. It would have the tendency to shift
leave room for discretion,” Volcker said, noting price
decisions to politicians, might well stigmatize coun- stability as a prevailing central tenet.

lessons learned: 1) Fed policy leads Mexican policy;
2) the Fed’s orientation is domestic and spillovers
are global, reflecting the dollar’s status as a reserve
currency; 3) the International Monetary Fund (IMF)
is the only institution with the responsibility for
global financial stability. In the future, Fed actions
must reflect a coordinated approach with the IMF.

42 FEDERAL RESERVE BANK OF DALLAS • Globalization and Monetary Policy Institute 2014 Annual Report

Central banks,
beginning in the
late 19th century,
lived in a world
without systemically
important financial
institutions and
a nonglobalized
financial market.

The policymaker panel

Volcker reviewed the 1984 collapse of
Continental Illinois Bank of Chicago, when the
Federal Deposit Insurance Corp.’s bailout of the
bank included guarantees to depositors as well
as bondholders, a prelude to today’s discussion of
too-big-to-fail institutions. In the current context, the
nation’s banks resist downsizing, Volcker said. “My
problem is that you can’t break them up enough to
make them go away.” Shadow banks and derivatives
markets pose an even greater threat than banks,
which have become “less important than the rest of
the market.”
Looking to the future, the Federal Reserve
remains a valuable institution. “It retains a respect
and independence that is unique among regulatory agencies,” Volcker said. “You can’t have a strong
regulatory system without the Federal Reserve.”

policy yields superior economic performance,
especially relative to the 1970s immediately following Bretton Woods’ demise when policy was “highly
discretionary and unfocussed.” In subsequent
years, reliance on rules-based policymaking broke
down following the Great Moderation of the 1990s,
including during the recent economic crisis, leading
to tensions among advanced countries and with
emerging economies, Taylor said.
Policymakers kept rates “too low, too long”
during the 2000s, relative to what a rules-based
approach (such as Taylor’s namesake Taylor rule)
would prescribe. Pointing to policy shortcomings
that aren’t confined to the U.S., he said various
central banks’ unconventional interventions, such
as bond purchases, have the net effect of leaving
the participants likely worse off than had they
followed a rules-based approach. Increasingly,
In Support of Rules-Based Policy
there is a trade-off in favor of output stability over
The third and final conference session, “Global- price stability. In a two-country situation in which
ization 2.0: Monetary Policy in a Global Context:
Country 1 seeks very low interest rates, Country 2
Past, Present and Future,” offered a forward view.
could well react with concern about exchange rate
Taylor, who also chairs the Globalization and Monappreciation and keep its rate too low—relative to
etary Policy Institute’s advisory board, presented his what a rules-based approach would suggest—ultimately causing increased price volatility and output
paper “The Federal Reserve in a Globalized World
instability.
Economy.” It argues that rules-based monetary
In real life, Fed quantitative easing in response
to the financial crisis prompted Japan’s central bankers to employ a set of unconventional measures
including large-scale asset purchases to offset
currency appreciation against the dollar and to
bolster economic output, Taylor said. Similarly, the
ECB’s moves toward asset purchases also reflect a
response to Fed policy and its global repercussions.
The cycle of policy action and reaction may seek to
thwart competitive devaluation but could end up
becoming an interest rate war or “an unconventional
monetary policy war.”
Taylor urged a return to a rules-based
approach, suggesting Congress pass legislation
requiring the Fed to report which rules it is following and the strategy employed. Such action would
help diminish volatile capital flows reacting to “fear
of free-falling exchange rates.” The Fed as a global
leader would push other central banks to return to
greater rules-based policy, Taylor said.
Conference participants commenting on the
Taylor paper suggested that imposition of rules may
be inappropriate in some circumstances. Kohn said

Globalization and Monetary Policy Institute 2014 Annual Report • FEDERAL RESERVE BANK OF DALLAS 43

in “unusual and exigent circumstances.”
The provision was used when the Fed
established liquidity facilities in the wake of the
Penn Central bankruptcy in 1970 to ensure availability of short-term corporate funding after the
commercial paper market seized up. Following
the Continental Illinois Bank collapse of 1984,
the Fed feared a resulting panic and installed full
insurance for all creditors, making them whole—in
the process raising moral hazard concerns in the
context of too-big-to-fail institutions.
The 1987 stock market crash prompted
concerns about the stability of the clearing and
settlement system of the stock and futures markets. The Fed provided liquidity to banks, which,
in turn, provided brokers with funds in the hope of
averting a larger shock. Fed involvement proved
short-lived, and a recession was averted. The central bank again took action during the Long-Term
Unprecedented Actions
Capital Management collapse in 1999, helping
Become the Norm
form a 16-bank consortium that helped avoid a
The conference’s final paper was “Unpreceformal default. The crisis highlighted the ability of
dented Actions: The Federal Reserve’s Response to nonbanks such as hedge funds to create financial
the Global Financial Crisis in Historical Perspecinstability. Fed reductions of the fed funds rate
tive,” by Frederic Mishkin, a Fed governor from
in support of the rescue contributed to what was
2006 to 2008 and banking professor at Columbia
labeled the “Greenspan put”—named after then
University, and Eugene White, a Rutgers UniverFed Chairman Alan Greenspan—a form of moral
sity economics professor. Their paper proposed
hazard in which financial institutions expect
that despite the “triumph of rules over discretion” monetary policy to help them recover from bad
during the Great Moderation, central bank imple- investments, Mishkin and White noted.
mentation of unprecedented measures is more
Mishkin and White argued that, rather than
the norm than the exception and the product of
strictly following rules, central banks should follow
reconciling central bank mandates for price stabil- contingent rules that limit moral hazard. Unprecity and financial stability.
edented Fed actions should be judged not by
Central banks, beginning in the late 19th
whether discretion was employed, but instead by
century, lived in a world without systemically imwhether their imposition adequately constrained
portant financial institutions and a nonglobalized moral hazard.
financial market. Policymakers could simply folDiscussant Steven Kamin of the Federal
low English essayist Walter Bagehot’s proposition Reserve Board of Governors, said policymakers
that when fulfilling lender-of-last-resort responshould avoid deviating from stability rules. The
sibilities, central banks should lend freely, charge
paper, he suggested, “didn’t discuss implementing
a premium and do business only with solvent
incentives aimed at avoiding liquidity risk.”
institutions. Adherence to this doctrine has given
Former Fed Chairman Volcker, responding to
way to contingent rules and preemptive actions to the paper, said the scope of future Fed crises could
handle adversity. Reliance on a Bagehot-like rule
grow even larger with the dollar, as the global
during the banking panics of 1930–33 deepened
reserve currency, under attack. “Sooner or later, if
the Depression and motivated the provisions of
the dollar ever comes into question, we will have
the Banking Act of 1935 providing the Fed with au- a real problem in the world economic situation …
thority for “unprecedented discretionary” actions in the political situation,” he said, suggesting that
that while the Fed was clear in its 2 percent inflation
target, adherence to the Taylor rule amid the financial crisis would have pushed rates below the target,
with effects spreading beyond the U.S. Discussant
Richard Clarida, Columbia University professor
of economics, said Taylor’s logic was “impeccable”
but doesn’t account for a collection of central bank
policies that, while reflecting cooperation among
policymakers, may be misguided or the result of
misreading a given situation—“cooperation is easy to
implement—just don’t make the policy mistake and
revert to non-cooperative optimal,” he said. More
than three years later, Clarida said, it remains difficult to see whether global policymaker decisions—
many following Taylor rule thinking initially—are
more the result of a common problem or a common
response that encountered a zero-bound constraint.
The result is that “QE begets QE.”

thought be given to the dollar’s replacement as a
world currency.
At the Forefront of a Global Economy

Thus, the conference came full circle—beginning with the U.S. economy emerging on the
world stage in the era of the gold standard and
concluding on a note of concern about future
implications of the dollar’s role as the preeminent
global reserve currency and the Fed’s standing as
the global central bank.
During the Federal Reserve System’s first
years, policymakers worked to establish a durable
institutional framework and learned in the initial
years of the Great Depression the extent of their
powers, only to subsequently discover limitations
when they tightened policy too quickly, lengthening and deepening the Depression.
Working with the U.S. Treasury to keep a
lid on federal funding expenses during WWII
and immediately afterward, the Fed in the 1950s
oversaw a decade of economic expansion. It was
a time when the Fed could concentrate on the
domestic impacts of its policies as the Treasury
took on international aspects. A mounting U.S.
balance of payments deficit hastened the demise
of the postwar Bretton Woods system of dollargold anchored exchange rates in the early 1970s,
and less than a decade later, the Volcker-led Fed
confronted double-digit U.S. inflation.
In an era of floating exchange rates in which
the dollar stood as the world’s reserve currency,
100 years after the Fed’s founding, its policies
carry increasingly broad implications. The recent
financial crisis, with its roots in the U.S. mortgage
market and its continuing reverberations in
Europe and Japan, illustrates the globalization of
finance and of Fed monetary policy.
As the Fed carries out its dual mandate of ensuring stable prices and maximum employment in
the U.S., central bankers must increasingly weigh
international responses that bear on the central
bank’s ability to achieve its goals. Still, conference
participants suggested, a prudent domestically
focused approach may offer the best opportunities
for achieving success that extends beyond the U.S.
and aids global growth.

44 FEDERAL RESERVE BANK OF DALLAS • Globalization and Monetary Policy Institute 2014 Annual Report

Institute Working Papers Issued in 2014
Working papers can be found online at
www.dallasfed.org/institute/wpapers/index.cfm.

No. 167
The Boy Who Cried Bubble: Public Warnings
against Riding Bubbles

Yasushi Asako and Kozo Ueda
No. 168
Vertical Integration and Supplier Finance

Erasmus Kersting and Holger Görg
No. 169
A Contribution to the Chronology of Turning
Points in Global Economic Activity (1980–2012)

No. 176
What Drives the German Current Account?
And How Does it Affect Other EU Member
States?

No. 185
Learning to Export from Neighbors

Robert Kollmann, Marco Ratto, Werner Roeger,
Jan In’t Veld and Lukas Vogel

No. 186
The Domestic Segment of Global Supply
Chains in China under State Capitalism

No. 177
Error Correction Dynamics of House Prices:
An Equilibrium Benchmark

Heiwai Tang, Fei Wang and Zhi Wang

Charles Ka Yui Leung

Valerie Grossman, Adrienne Mack and Enrique
Martínez-García

No. 178
Credit Booms, Banking Crises, and the
Current Account

No. 170
Monetary Policy Shocks and Foreign
Investment Income: Evidence from a
Large Bayesian VAR

J. Scott Davis, Adrienne Mack, Wesley Phoa and
Anne Vandenabeele

Simone Auer

Ana Fernandes and Heiwai Tang

No. 187
Pricing-to-Market and Optimal Interest
Rate Policy

Dudley Cooke
No. 188
The Redistributional Consequences of Tax
Reform Under Financial Integration

Ayse Kabukçuoglu
No. 179
The Role of Direct Flights in Trade Costs

Demet Yilmazkuday and Hakan Yilmazkuday

No. 189
Assessing Bayesian Model Comparison in
Small Samples

No. 171
Capital Controls as an Instrument of
Monetary Policy

No. 180
Theory and Practice of GVAR Modeling

Enrique Martínez-García and Mark A. Wynne

Scott Davis and Ignacio Presno

Alexander Chudik and M. Hashem Pesaran

No. 172
Trade Linkages and the Globalisation of
Inflation in Asia and the Pacific

No. 181
International Capital Flows and the
Boom-Bust Cycle in Spain

No. 190
Technical Note on “Assessing Bayesian
Model Comparison in Small Samples”

Raphael Auer and Aaron Mehrotra

Jan In’t Veld, Robert Kollmann, Beatrice
Pataracchia, Marco Ratto and Werner Roeger

No. 191
Benefits of Foreign Ownership: Evidence
from Foreign Direct Investment in China

No. 182
Very Long-Run Discount Rates

Jian Wang and Xiao Wang

Stefano Giglio, Matteo Maggiori and Johannes
Stroebel

No. 174
Inflation Targeting and the Anchoring of
Inflation Expectations: Cross-country
Evidence from Consensus Forecasts

No. 192
Trade Partner Diversification and Growth:
How Trade Links Matter

No. 183
Capital Goods Trade and Economic
Development

Ali Sina Önder and Hakan Yilmazkuday

J. Scott Davis

Piyusha Mutreja, B. Ravikumar and Michael Sposi

No. 175
Banking on Seniority: The IMF and the
Sovereign’s Creditors

No. 184
Bank Crises and Sovereign Defaults in
Emerging Markets: Exploring the Links

Aitor Erce

Irina Balteanu and Aitor Erce

No. 173
Minimum Wages and Firm Employment:
Evidence from China

Yi Huang, Prakash Loungani and Gewei Wang

Enrique Martínez-García and Mark A. Wynne

No. 193
What Drives Housing Dynamics in China?
A Sign Restrictions VAR Approach

Timothy Yang Bian and Pedro Gete

Globalization and Monetary Policy Institute 2014 Annual Report • FEDERAL RESERVE BANK OF DALLAS 45

No. 194
Working Less and Bargain Hunting More:
Macro Implications of Sales during Japan’s
Lost Decades

No. 203
The International Monetary and Financial
System: Its Achilles Heel and What to Do
About It

Nao Sudo, Kozo Ueda, Kota Watanabe and
Tsutomu Watanabe

Claudio Borio

No. 195
Doctrinal Determinants, Domestic and
International, of Federal Reserve Policy
1914–1933

Barry Eichengreen
No. 196
Real Exchange Rate and Sectoral
Productivity in the Eurozone

Martin Berka, Michael B. Devereux and
Charles Engel

No. 204
The International Monetary and Financial System: A Capital Account Historical Perspective

Michael B. Devereux and Changhua Yu

David Cook and Michael B. Devereux
No. 199
Intra-Safe Haven Currency Behavior During
the Global Financial Crisis

Rasmus Fatum and Yohei Yamamoto
No. 200
The Federal Reserve in a Globalized World
Economy

John B. Taylor
No. 201
Stability or Upheaval? The Currency
Composition of International Reserves in the
Long Run

No. 213
A Multi-Country Approach to Forecasting
Output Growth Using PMIs

Alexander Chudik, Valerie Grossman and
M. Hashem Pesaran

No. 205
Navigating Constraints: The Evolution of
Federal Reserve Monetary Policy, 1935–59

No. 214
The Macroeconomic Effects of Debt- and
Equity-Based Capital Inflows

Mark A. Carlson and David C. Wheelock

J. Scott Davis

No. 206
Federal Reserve Policy and Bretton Woods

No. 215
Geographic Barriers to Commodity Price
Integration: Evidence from U.S. Cities and
Swedish Towns, 1732–1860

No. 207
Can Interest Rate Factors Explain Exchange
Rate Fluctuations?

Julieta Yung
No. 198
Exchange Rate Flexibility under the Zero
Lower Bound

Robert Kollmann

Claudio Borio, Harold James and Hyun Song Shin

Michael D. Bordo and Owen F. Humpage
No. 197
International Financial Integration and
Crisis Contagion

No. 212
Exchange Rates Dynamics with Long-Run
Risk and Recursive Preferences

Mario J. Crucini and Gregor W. Smith
No. 216
Noisy Information, Distance and Law of One
Price Dynamics Across U.S. Cities

No. 208
No Price Like Home: Global House Prices,
1870–2012

Mario J. Crucini, Mototsugu Shintani and
Takayuki Tsuruga

Katharina Knoll, Moritz Schularick and
Thomas Steger

No. 217
Trends and Cycles in Small Open Economies:
Making the Case for a General Equilibrium
Approach

No. 209
Unprecedented Actions: The Federal
Reserve’s Response to the Global Financial
Crisis in Historical Perspective

Frederic S. Mishkin and Eugene N. White

Kan Chen and Mario Crucini
No. 218
Aging and Deflation from a Fiscal Perspective

Mitsuru Katagiri, Hideki Konishi and Kozo Ueda
No. 210
The Federal Reserve Engages the World
(1970–2000): An Insider’s Narrative of the
Transition to Managed Floating and Financial
Turbulence

No. 219
The Role of Two Frictions in Geographic Price
Dispersion: When Market Friction Meets
Nominal Rigidity

Edwin M. Truman

Chi-Young Choi and Horag Choi

No. 211
Hot Money and Quantitative Easing: The
Spillover Effects of U.S. Monetary Policy on
Chinese Housing, Equity and Loan Markets

No. 220
Japan’s Financial Crises and Lost Decades

Barry Eichengreen, Livia Chitu and Arnaud Mehl
No. 202
A Threshold Model of the U.S. Current Account

Roberto Duncan

Steven Wei Ho, Ji Zhang and Hao Zhou

Naohisa Hirakata, Nao Sudo, Ikuo Takei and
Kozo Ueda

46 FEDERAL RESERVE BANK OF DALLAS • Globalization and Monetary Policy Institute 2014 Annual Report

Institute Staff, Advisory Board
and Senior Fellows
Institute Director

Board of Advisors

Mark A. Wynne

John B. Taylor, Chairman
Vice President and Associate Director of Research, Senior Fellow, Hoover Institution
Federal Reserve Bank of Dallas
Mary and Robert Raymond Professor of Economics,
Stanford University
Staff
Undersecretary of the Treasury for International
Affairs, 2001–05
Jian Wang

Horst Köhler

President, Federal Republic of Germany, 2004–10
Managing Director, International Monetary Fund,
2000–04
Finn Kydland

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

Senior Research Economist and Advisor

Charles R. Bean

Alexander Chudik

Deputy Governor, Bank of England, 2008–14
Executive Director and Chief Economist,
Bank of England, 2000–08

Guillermo Ortiz

Enrique Martínez-García

Martin Feldstein

Kenneth S. Rogoff

Senior Research Economist

George F. Baker Professor of Economics,
Harvard University
President Emeritus, National Bureau of
Economic Research

Thomas D. Cabot Professor of Public Policy,
Harvard University
Director of Research, International Monetary
Fund, 2001–03

Janet Koech

Heng Swee Keat

Masaaki Shirakawa

Assistant Economist

Minister for Education, Parliament of Singapore
Managing Director, Monetary Authority of
Singapore, 2005–11

Director and Vice Chairman, Bank for
International Settlements
Governor, Bank of Japan, 2008–13
Professor, School of Government, Kyoto University
2006–08

Senior Research Economist
Scott Davis

Governor, Bank of Mexico, 1998–2009

Senior Research Economist

Michael J. Sposi

Research Economist
Julieta Yung

Research Economist

Valerie Grossman

Research Analyst
Bradley Graves

Research Assistant

R. Glenn Hubbard

Kuhu Parasrampuria

Dean and Russell L. Carson Professor of Finance
and Economics, Graduate School of Business,
Columbia University
Chairman, Council of Economic Advisers, 2001–03

Research Assistant

Otmar Issing

President, Center for Financial Studies (Germany)
Executive Board Member, European Central Bank,
1998–2006

William White

Head of the Monetary and Economic
Department, Bank for International Settlements,
1995–2008

Globalization and Monetary Policy Institute 2014 Annual Report • FEDERAL RESERVE BANK OF DALLAS 47

Senior Fellows
Michael Bordo

Professor of Economics, Rutgers University
Research Associate, National Bureau of Economic
Research
Mario Crucini

Professor of Economics, Vanderbilt University
Research Associate, National Bureau of Economic
Research

New Staff at the Institute

Bradley Graves

Research Assistant
Graves has been a research assistant for the
Globalization and Monetary Policy Institute
since June 2014. He graduated from Southern
Methodist University in 2014 with a BS in
economics and a BS in biological sciences. He is
a native of Olathe, Kan.

Michael B. Devereux

Professor of Economics, University of British
Columbia
Visiting Scholar, International Monetary Fund
Charles Engel

Professor of Economics, University of Wisconsin–
Madison
Research Associate, National Bureau of Economic
Research
Karen Lewis

Joseph and Ida Sondheimer Professor of
International Economics and Finance, Wharton
School, University of Pennsylvania
Codirector, Weiss Center for International
Financial Research, 2005–11
Francis E. Warnock

James C. Wheat Jr. Professor of Business
Administration, Darden Graduate School
of Business, University of Virginia
Research Associate, National Bureau of Economic
Research
Research Associate, Institute for International
Integration Studies, Trinity College Dublin

Kuhu Parasrampuria

Research Assistant
Parasrampuria is a research assistant for the
Globalization and Monetary Policy Institute.
She graduated from the University of Rochester
in 2013 with a BA in economics and business
strategies and minors in classical civilizations and
philosophy. Parasrampuria worked as an analyst
at JP Morgan Chase before joining the Fed. She is
from Philadelphia.
Julieta Yung

Research Economist
Yung joined the Research Department at the
Dallas Fed in July 2014. Her primary research
fields are financial economics, international
economics and macroeconomics, with a focus
on term structure models of interest rates and
exchange rates. Originally from Argentina, she
holds a PhD in economics from the University of
Notre Dame.

48 FEDERAL RESERVE BANK OF DALLAS • Globalization and Monetary Policy Institute 2014 Annual Report

Research Associates
Raphael Auer

Peter Egger

Swiss National Bank

Eidgenössische Technische Hochschule Zürich

Simone Auer

Aitor Erce

Swiss National Bank

Bank of Spain

Chikako Baba

Ester Faia

International Monetary Fund

Goethe University Frankfurt

Pierpaolo Benigno

Rasmus Fatum

LUISS Guido Carli

University of Alberta School of Business

Martin Berka

Andrew Filardo

Victoria University of Wellington

Bank for International Settlements

Saroj Bhattarai

Andreas Fischer

Pennsylvania State University

Swiss National Bank

Javier Bianchi

Marcel Fratzscher

University of Wisconsin–Madison

German Institute for Economic Research

Claudio Borio

Ippei Fujiwara

Bank for International Settlements

Australian National University

Hafedh Bouakez

Pedro Gete

HEC Montréal

Georgetown University

Matthieu Bussière

Bill Gruben

Banque de France

Texas A&M International University

Matteo Cacciatore

Sophie Guilloux

HEC Montréal

Bank of France

Alessandro Calza

Ping He

European Central Bank

Tsinghua University

Bo Chen

Gee Hee Hong

Shanghai University of Finance and Economics

Bank of Canada

Hongyi Chen

Yi Huang

Hong Kong Institute for Monetary Research

The Graduate Institute Geneva

Yin-Wong Cheung

Erasmus Kersting

University of California, Santa Cruz/
City University of Hong Kong
C.Y. Choi*
University of Texas at Arlington

Villanova University

Dudley Cooke

Bureau of Labor Statistics

University of Exeter Business School
German Cubas*
University of Houston

Robert Kollmann

Richard Dennis

Charles Ka Yui Leung

Australian National University

City University of Hong Kong

Roberto Duncan

Nan Li

Ohio University

Ohio State University

Enisse Kharroubi

Bank for International Settlements
Mina Kim

European Centre for Advanced Research in
Economics and Statistics

Globalization and Monetary Policy Institute 2014 Annual Report • FEDERAL RESERVE BANK OF DALLAS 49

Shu Lin

Shigenori Shiratsuka

Fudan University

Bank of Japan

Tuan Anh Luong

Ina Simonovska

Shanghai University of Finance and Economics

University of California, Davis

Julien Martin

L. Vanessa Smith

Paris School of Economics

University of Cambridge

Césaire Meh

Jens Søndergaard

Bank of Canada

Capital Strategy Research

Arnaud Mehl

Bent E. Sorensen

European Central Bank
Swiss National Bank

University of Houston
Heiwai Tang*
Johns Hopkins University

Fabio Milani

Cédric Tille

University of California, Irvine
Philippe Moutot

Graduate Institute for International and
Development Studies

European Central Bank

Ben A.R. Tomlin

Daniel Murphy

Bank of Canada

University of Virginia
Piyusha Mutreja*
Syracuse University

Kozo Ueda

Deokwoo Nam

University of Virginia

City University of Hong Kong

Giovanni Vitale

Dimitra Petropoulou

European Central Bank

University of Sussex

Xiao Wang

Vincenzo Quadrini

University of North Dakota

University of Southern California

Yong Wang

Attila Rátfai

Hong Kong University of Science and Technology

Central European University

Tomasz Wieladek

Kim Ruhl

London Business School

Stern School of Business

Hakan Yilmazkuday

Katheryn Russ

Florida International University

University of California, Davis

Jianfeng Yu

Filipa Sa

University of Minnesota

University of Cambridge

Zhi Yu

Raphael Schoenle

Shanghai University of Finance and Economics

Brandeis University

Yu Yuan

Giulia Sestieri

University of Iowa

Simone Meier

Waseda University, Tokyo
Eric van Wincoop

Banque de France
Etsuro Shioji

Hitotsubashi University

*New to the institute in 2014.

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