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Summary GFG Material Week 5
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The trilemma today, Rey (2013), and Georgiadis and Mehl (2016)
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W5 - Lecture prepDecember 13, 2022 2:20 PM
Title: The Trilemma Today: The Global Financial Cycle and Central Banks
• Global financial cycle (GFC): co-movement of gross K flows, credit growth, leverage,
WI the GFC?
risky asset prices around the globe.
HD the US interest • US interest rate is one of the drivers of the global financial cycle.
rate affect the GFC? ○ An increase in the Fed's rate causes (step by step):
▪ The leverage of financial intermediaries go down.
▪ K flows decrease.
▪ Funding conditions tighten.
□ Countries that rely heavily on USD funding (or have a dollarized
financial system) might face more severe K outflows and
potentially issues with investments.
□ How strong these K outflows will be depends on country
specific features (e.g.: size of country's external balance sheet,
country's econ. outlook)
YD US rates affect
int'l liquidity? • The US is at the center of the int'l monetary system (large international banks
and financial institutions depend on dollar funding, and the USD is the asset used
by asset managers), so its rates affect international liquidity.
WD Rey's findings • Policy implications of Rey's findings: (emerging) markets cannot necessarily hit their
mean for emerging optimal target of inflation/output stabilization in a world where a global financial cycle
markets' monetary
policy is important.
effectiveness? • The interest rate is not enough to achieve domestic targets, even when a
country has an adjustable XR.
D an adjustable XR
or developed K • There's transmission of global financial cycles happens even to advanced
markets shield the economies (e.g.: UK, Sweden, Canada) with floating XRs and developed K
economy from foreign markets.
interest rate
changes? ○ Additional tools are needed. Each country needs to work out its optimal
mix of tools depending on their institutions. Some options:
WR some of the tools
▪ Macroprudential tools: depending on the type of transmission of the
that could help global financial cycle (e.g.: dollarization of BS, financial stability
increase monetary problem, other frictions…) different tools are needed.
policy
effectiveness? □ How to use these tools depends on theoretical modelling.
□ Might not be potent enough in some countries (e.g.: where
banking system is not well developed and there is a lot of
market finance).
▪ K controls.
WI the effect of • Emerging markets with pegs and exposure to sudden stops face a larger risk of crisis
int'l reserves? the smaller their reserve holdings, holding constant the size of any flight shock.
• Financial stability motives help explain reserve growth: The monetary policy
trilemma constraint affect the reserve cushions needed to weather banking
crises.
○ More reserves are held by countries with:
WR the 4 features
that motivate ▪ Financially open (open KA).
holding more ▪ Deep financial markets countries (i.e.: large gross K flows).
reserves (to ensure □ Increasingly important for emerging markets.
financial
stability)? ▪ Pegged XR.
□ Weaker for emerging market sample.
▪ Trade openness (open CA).
YR countries ○ Conclusion: recent reserve accumulation is partly explained by concerns for
increasingly holding financial stability in the face of open K markets and pegged XRs (Euro zone
more int'l reserves? position on policy trilemma).
Global Finance and Growth Page 62
, • Financial development played a major role in stimulating precautionary reserve
accumulation in Emerging Markets (EMs).
• Precautionary concern:
WR the precautionary ○ Is not via the "sudden stop" argument: to have a buffer against the inability
concerns that of domestic residents to issue new external liabilities.
stimulated reserve
holdings by EMs? ○ Is mostly via the "sudden flight" argument: to safeguard against the sudden
wish of domestic residents to acquire external assets
▪ More liquid assets (i.e.: liquid liabilities of the banking system) have
greater flight risks.
Acc. to Rey: • Rey's main takeaways:
*WI the current
dilemma? 1. In today's globalized world, the trilemma may really be a dilemma: you can have
open KA and no policy freedom, or closed KA and policy freedom.
*W drives K flows?
○ Even with floating XRs, K flows are driven by the global financial cycle
(rather than by individual countries' XR choices).
○ In practice, policy makers can take an intermediate position to partially
*H should K flows be have both.
interpreted 2. K flows need to be interpreted differently.
differently? ○ A country's increase in K inflows may be led by an increase in global risk
appetite (that drives increased K flows everywhere) rather than by an
increased attractiveness of a country to foreign investors (e.g.: lowering
wages or giving tax breaks).
W drives the GFC?
(3) • Some more background:
○ The global financial cycle can be related to monetary conditions in the US
and to changes in risk aversion and uncertainty.
HD the US monetary
conditions affect ▪ Monetary conditions in the US affects leverage of global banks, K
the int'l monetary flows, and credit growth in int'l monetary system.
system? □ Whenever K is freely mobile, the global financial cycle
constraints national monetary policies (regardless of XR
regime).
○ As credit cycles and capital flows obey global factors, they may be
YI this very inappropriate for the cyclical conditions of many economies.
relevant for ▪ For some countries, the global cycle can lead to excessive credit
macroeconomic growth in boom times (that can fuel a crisis due to asset bubbles)
policy?
and excessive retrenchment in bad times.
Summary: Global financial cycle (GFC): co-movement of gross K flows, credit growth, leverage, risky asset prices
around the globe. It is partially driven by the US monetary policy, affecting leverage of int'l financial intermediaries, K
flows, and funding conditions. This interplay is because of int'l dependence on dollar funding.
Rey argues that financial globalization has made monetary policy less effective, as K flows are driven by the GFC rather
than by domestic factors (e.g.: XR regime or developed K markets). Due to this reduced effectiveness, countries may
need additional tools (i.e.: macroprundential tools and even K controls).
Holding int'l reserves also helps cushion the trilemma constraints. More reserves are needed if: (i) open financial
accounts; (ii) deep financial markets; (iii) pegged XR; (iv) trade (CA) openness. Countries are accumulating increasingly
more reserves to foster financial stability. Financial developments (globalization) stimulated reserve accumulation (to
safeguard against a sudden flight of K).
Acc. to Rey, the trilemma has become a dilemma (open KA or policy freedom, but theoretically not both). This because
even with a floating XR, K flows are driven by GFC. In practice, they can have partially both with an intermediate
position. K inflows might be led by a global increase in risk appetite as opposed to an increase in relative
attractiveness of a country. Thus, K flows are driven by US monetary policy and its influence on elasticity of int'l
financial markets. This could be counterproductive for the cyclical conditions of many countries (fueling excessive
credit growth in good times and possibly asset bubbles, but risking excess retrenchment in bad times).
Global Finance and Growth Page 63
, W5 - Rey, 2013
December 12, 2022 10:24 AM
Title: The Global Financial Cycle and Monetary Policy Independence
Future learn
• This week we learn how global factors may be more important than domestic factors
in understanding capital (K) flows, and how financial flows may limit monetary policy
space.
• Rey shows how K flows seem to be driven by the US/European centred global K
market, not by domestic factors.
• Implications:
1. Domestic policy makers with open K accounts will have to follow US
interest rates, so they have no monetary policy freedom of their own.
▪ Trilemma says that this is the case with fixed XR. But Rey shows that
it may also be the case with floating rates, since K flows are driven
by the global cycle, not by individual countries XR choices.
□ In today’s globalized world, the trilemma may really be a
dilemma, where countries can choose:
Open K accounts and no policy freedom.
Closed K accounts and policy freedom.
▪ In practice, policymakers can choose a position in between,
managing K flows to some degree if they want monetary policy
freedom to some degree.
2. K flows might demand a different interpretation: we usually think that a
country received much K from abroad because it has made itself more
attractive to foreign investors (e.g.: by lowering wages or giving tax breaks
to foreigners). In fact the reason may simply be that global risk appetite
has increased and K flows have increased everywhere (it's the global
cycle, stupid!).This cautions against looking for domestic factors only when
trying to understand K inflows
Introduction
• The globalization of the financial cycle – characterized by the increasing
interconnectedness of the global economy and the transmission of financial booms
and busts across borders – has several implications for monetary policy.
1. Global considerations as opposed to domestic: Central banks can no longer rely
on domestic factors alone to guide their policy decisions. Instead, they must
consider the impact of their actions on the global economy as a whole.
2. Compromises for financial stability: Central banks may have to forgo some of
their traditional independence in order to coordinate their actions with those of
other central banks and avoid destabilizing the global financial system.
• The role of XR regimes in the global financial cycle (GFC): both regimes are sensitive to
financial crises, and neither provides a complete shield against int'l K developments.
• Fixed XR regimes (e.g.: those of many emerging market countries) can be
particularly vulnerable to financial crises, as they limit the ability of central banks
to use monetary policy to respond to economic shocks.
• Floating XR regimes (e.g.: those of most developed countries) provide more
flexibility for central banks to respond to economic shocks, but can also lead to
volatility in the exchange rate.
The Global Financial Cycle and International Capital Flows:
• The impact of the globalization of the financial cycle on international K flows:
• The increasing interconnectedness of the global economy has led to a situation
where financial booms and busts are transmitted across borders through a
variety of channels, including trade, financial markets, and cross-border lending.
Global Finance and Growth Page 64
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