Financial globalization and monetary transmission

Abstract

This article studies the way in which international financial integration affects the domestic transmission of monetary policy in a standard New Keynesian open economy model. It extends Woodford's (2010) model to a framework, in which not only a global integration of goods and factor markets, but also financial markets might matter for the monetary transmission mechanism. The article considers two broad types of experiments meant to capture financial integration, a decrease in the costs of international asset trading and an increase in the level of gross foreign asset holdings. The main finding is that none of the analyzed forms of financial integration undermine the effectiveness of monetary policy in influencing domestic output and inflation. On the contrary, under a wide array of parameterizations, and even in an environment where the exchange rate pass‐through elasticity is very low and the Home country's traded goods sector is very small compared to world markets, monetary policy is more, rather than less, effective as the positive impact of strengthened exchange rate and wealth channels more than offsets the negative impact of weakened interest rate channels. Monetary policy is most effective in simulations interacting the highest degrees of the two forms of financial integration.