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The Global Factor in Neutral Policy Rates: Some Implications for Exchange Rates, Monetary Policy, and Policy Coordination

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  • Richard H. Clarida
Abstract
This paper highlights some of the theoretical and practical implications for monetary policy and exchange rates that derive specifically from the presence of a global general equilibrium factor embedded in neutral real policy rates in open economies. Using a standard two country DSGE model, we derive a structural decomposition in which the nominal exchange rate is a function of the expected present value of future neutral real interest rate differentials plus a business cycle factor and a PPP factor. Country specific “r*” shocks in general require optimal monetary policy to pass these through to the policy rate, but such shocks will also have exchange rate implications, with an expected decline in the path of the real neutral policy rate reflected in a depreciation of the nominal exchange rate. We document a novel empirical regularity between the equilibrium error in the VECM representation of the empirical Holston Laubach Williams (2017) four country r* model and the value of the nominal trade weighted dollar. In fact, the correlation between the dollar and the 12 quarter lag of the HLW equilibrium error is estimated to be 0.7. Global shocks to r* under optimal policy require no exchange rate adjustment because passing though r* shocks to policy rates ‘does all the work’ of maintaining global equilibrium. We also study a richer model with international spill overs so that in theory there can be gains to international policy cooperation. In this richer model we obtain a similar decomposition for the nominal exchange rate, but with the added feature that r* in each country is a function global productivity and business cycle factors even if these factors are themselves independent across countries. We argue that in practice, there could well be significant costs to central bank communication and credibility under a regime formal policy cooperation, but that gains to policy coordination could be substantial given that r*’s are unobserved but are correlated across countries.

Suggested Citation

  • Richard H. Clarida, 2017. "The Global Factor in Neutral Policy Rates: Some Implications for Exchange Rates, Monetary Policy, and Policy Coordination," NBER Working Papers 23562, National Bureau of Economic Research, Inc.
    • Handle: RePEc:nbr:nberwo:23562
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    Cited by:

    1. Boris Hofmann & Marco Jacopo Lombardi & Benoit Mojon & Athanasios Orphanides, 2021. "Fiscal and monetary policy interactions in a low interest rate world," BIS Working Papers 954, Bank for International Settlements.
    2. Claudio Borio & Piti Disyatat & Mikael Juselius & Phurichai Rungcharoenkitkul, 2022. "Why So Low for So Long? A Long-Term View of Real Interest Rates," International Journal of Central Banking, International Journal of Central Banking, vol. 18(3), pages 47-87, September.
    3. Zhang, Ren & Martínez-García, Enrique & Wynne, Mark A. & Grossman, Valerie, 2021. "Ties that bind: Estimating the natural rate of interest for small open economies," Journal of International Money and Finance, Elsevier, vol. 113(C).
    4. Claudio Borio & Piti Disyatat & Mikael Juselius & Phurichai Rungcharoenkitkul, 2017. "Why so low for so long? A long-term view of real interest rates," BIS Working Papers 685, Bank for International Settlements.
    5. repec:zbw:bofrdp:2017_036 is not listed on IDEAS
    6. Thiago Revil T. Ferreira & Samer Shousha, 2020. "Scarcity of Safe Assets and Global Neutral Interest Rates," International Finance Discussion Papers 1293, Board of Governors of the Federal Reserve System (U.S.).
    7. Maurice Obstfeld, 2020. "Global Dimensions of U.S. Monetary Policy," International Journal of Central Banking, International Journal of Central Banking, vol. 16(1), pages 73-132, February.
    8. Martínez-García, Enrique, 2021. "Get the lowdown: The international side of the fall in the U.S. natural rate of interest," Economic Modelling, Elsevier, vol. 100(C).
    9. Òscar Jordà & Alan M. Taylor, 2019. "Riders on the Storm," FRBSF Economic Letter, Federal Reserve Bank of San Francisco.
    10. Thiago Revil T. Ferreira & Samer Shousha, 2021. "Supply of Sovereign Safe Assets and Global Interest Rates," International Finance Discussion Papers 1315, Board of Governors of the Federal Reserve System (U.S.).

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    JEL classification:

    • E4 - Macroeconomics and Monetary Economics - - Money and Interest Rates
    • F31 - International Economics - - International Finance - - - Foreign Exchange
    • F33 - International Economics - - International Finance - - - International Monetary Arrangements and Institutions

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