Understanding cross-border interdependencies and inspecting the international transmission mechanism of policy shocks is the raison d’être of open-economy macroeconomics as an intellectual discipline. The relevance for the policy debate is pervasive: over and over in the history of the international monetary system national policymakers have pointed at — and voiced concerns about—the effects of policy actions undertaken in foreign countries on the outlook and financial conditions in their own domestic economies. The most recent example involves the spillovers of tighter monetary policies aimed at addressing the inflationary spikes associated with the COVID-19 pandemic. In this three-part series, we provide a non-technical introduction to the multifaceted literature on global spillovers, building in particular on our own research. This post introduces the subject and offers an overview of the classic transmission channels.
Spillovers in Theory
Like most results in macroeconomics, the analysis of international spillovers is subject to a litany of caveats. Policy actions in one country can have welcome effects on the economies of its trading partners, by stimulating demand or curbing inflation. But they can also be potential sources of disruption and instability by inducing unwarranted capital inflows or outflows, spurring adverse currency fluctuations, and weighing on labor and product market conditions through their effects on terms of trade and net exports.
Concerns about the negative beggar-thy-neighbor effects of foreign policy developments have been particularly emphasized in emerging market economies, where a sizable fraction of households and firms have imperfect access to credit and financial markets, constraining their ability to reap the benefits of effective insurance opportunities against employment, income, and consumption risks related to foreign shocks. On net, the assessment of the size and sign of policy interdependencies has been – and remains – a point of controversy within the evergreen debate over the costs and benefits of flexible exchange rate regimes and policy coordination.
Expenditure Effects
A natural starting point to study the trade-offs associated with international spillovers is the textbook dichotomy between the so-called expenditure-switching and expenditure-changing effects emphasized in the classic Mundell-Fleming-Dornbusch theoretical paradigm in open-economy macroeconomics. Consider a simple thought experiment focused on the effects of a tighter monetary policy in a foreign country — say, an unanticipated hike in the interest rate controlled by its central bank – on the domestic economy. We will refer to the domestic economy as the home country and to the economy abroad as the foreign country.
Other things being equal, the higher interest rates prevailing abroad likely cause the home country’s exchange rate to depreciate vis-à-vis the foreign economy, as agents worldwide move funds into foreign-currency assets that carry higher yields. A weaker exchange rate in turn makes foreign goods and services more expensive from the vantage point of home-country consumers. Their rational response is to reallocate their expenditures toward (cheaper) domestic goods and reduce demand for (more expensive) imported goods. In parallel, home-country goods will be cheaper from the vantage point of foreign consumers, whose exchange rate has strengthened, and thus world demand moves from foreign-country to home-country goods. This is, in a nutshell, the expenditure-switching effect. If one visualizes global demand as a pie split into two slices—domestic output and foreign output—then the expenditure-switching effect associated with a monetary tightening abroad reduces the slice of foreign output and increases the slice of domestic output.
At the same time, the higher interest rates abroad curtail foreign incomes and generally create an incentive to postpone spending today and save more—that is, to substitute inter-temporally between current and future consumption. But this implies that current global demand for all kind of goods and services, both domestic and foreign, shrinks. In terms of our global-demand-as-pie metaphor, the size of the whole pie is now smaller thanks to the monetary tightening in the foreign country. This is the essence of the expenditure-changing effect associated with the intertemporal substitution channel.
Spillovers in Practice
Now the million-dollar question is: what happens to the actual size of world demand for home-country output? That is, is the size of the home country’s slice of the global pie bigger or smaller? Does a monetary contraction abroad increase or shrink home-country output? Is the international transmission of the policy shock positive or negative? The simple answer is: it depends. In practice, the relative size of the expenditure-switching and expenditure-changing effects can change over time and across countries. It has been argued that the two effects may pretty much offset each other, hinting that international spillovers are on average quite negligible.
Of course, this is not the end of the story. Far from it. Even at a very preliminary level, the list of variables affecting the assessment of global spillovers is interminable: country size, degree of openness, biases in consumer preferences, lags and frictions in the transmission mechanism, technological and institutional characteristics of labor and product markets, business cycle conditions, constraints on the international mobility of goods and services, and so on.
Additional Factors
However, two broad analytical dimensions that are typically overlooked in more traditional models are especially important for further theoretical and empirical investigations. One possibility is to acknowledge the obvious fact that economic agents have different propensities to consume out of their incomes and wealth, and that not all market participants face effective insurance opportunities to diversify risks to their employment and incomes over the business cycle. A parallel possibility is to pay closer attention to the role of financial markets and frictions. We will explore the details of both options in the next two posts in this series.
Read the next post in the series.
Sushant Acharya is an associate professor of economics at the University of Melbourne.
Ozge Akinci is head of International Studies in the Federal Reserve Bank of New York’s Research and Statistics Group.
Silvia Miranda-Agrippino is a research economist in the Federal Reserve Bank of New York’s Research and Statistics Group.
Paolo Pesenti is director of monetary policy in the Federal Reserve Bank of New York’s Research and Statistics Group.
How to cite this post:
Sushant Acharya, Ozge Akinci, Silvia Miranda-Agrippino, and Paolo A. Pesenti, “Monetary Policy Spillovers in the Global Economy,” Federal Reserve Bank of New York Liberty Street Economics, April 7, 2025, https://libertystreeteconomics.newyorkfed.org/2025/04/monetary-policy-spillovers-in-the-global-economy/.
Disclaimer
The views expressed in this post are those of the author(s) and do not necessarily reflect the position of the Federal Reserve Bank of New York or the Federal Reserve System. Any errors or omissions are the responsibility of the author(s).
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