Tipping the scale? The workings of monetary policy through trade

• Published date: 01 August 2020
• Author: Gustavo Adler,Carolina Osorio Buitron
• Date: 01 August 2020
• DOI: http://doi.org/10.1111/roie.12469

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wileyonlinelibrary.com/journal/roie Rev Int Econ. 2020;28:744–759.

© 2020 John Wiley & Sons Ltd

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INTRODUCTION

The 2008–2009 global financial crisis, and the prolonged period of subdued growth that followed,

led to aggressive use of monetary policy as a countercyclical tool, especially in advanced economies.

First came the sharp loosening of conventional monetary policy (CMP) tools, whereby short-term

policy rates were lowered to zero (Figure 1, Left Panel),1

rapidly followed by the implementation of

unconventional measures in the form of asset purchase programs and forward guidance (Figure 1,

Right Panel). Along with the wave of unconventional monetary policy (UMP) measures, first by the

US and later by the Euro Area, UK and other key systemic economies, came the discussion of whether

extraordinarily loose monetary policy entailed negative spillovers to the rest of the world (and partic-

ularly adverse effects associated with negative interest rates).2

Received: 28 August 2018

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Revised: 16 January 2020

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Accepted: 21 January 2020

DOI: 10.1111/roie.12469

ORIGINAL ARTICLE

Tipping the scale? The workings of monetary policy

through trade

GustavoAdler

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CarolinaOsorio Buitron

The International Monetary Fund retains copyright and all other rights in the manuscript of this article as submitted for

publication. The views expressed in this paper are those of the authors and do not necessarily represent the views of the IMF,

its Executive Board, or IMF management.

International Monetary Fund, Washington,

DC, USA

Correspondence

Gustavo Adler, International Monetary

Fund, 700 19th Street N.W., Washington,

DC 20431-0001, USA.

Email: gadler@imf.org

Abstract

The monetary policy entails demand-augmenting and di-

verting effects, and its impact on the trade balance—and on

other countries—depends on the magnitude of these oppos-

ing effects. Using U.S. data and a sign-restricted structural

vector autoregressive identification, we investigate the im-

portance of these effects. Overall, the results indicate that

a monetary loosening (tightening) leads to a strengthening

(weakening) of the overall trade balance, indicating that de-

mand diversion dominates. The paper also explores changes

in the effects following the global financial crisis, reflecting

the impaired monetary transmission mechanism.

JEL CLASSIFICATION

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ADLER AnD OSORIO BUITROn

Despite the flurry of research that followed, a consensus on the effects of monetary policy on other

economies and, especially the difference, or lack thereof, between the effects of UMP and CMP, has

yet to emerge.

In this paper, we take a fresh look at this issue. Using U.S. data, given the greater availability of

relevant series, we test whether monetary policy shocks have positive or negative spillovers to other

economies, based on their impact on the trade balance.

By studying the impact on the trade balance vis-a-vis trading partners with different exchange rate

regimes (fixed and flexible vis-à-vis the U.S. dollar) our work sheds light on the effects of monetary

policy through demand-augmenting and demand-diverting channels.

• Demand-augmenting effects refer to the impact of monetary policy on overall domestic demand,

due to the change in overall intertemporal consumption/saving decisions. Because changes in ag-

gregate demand entail lower or higher demand for both nontradable and tradable goods, they have

implications for the trade balance. Expansionary monetary policy, for example, tends to weaken the

trade balance by boosting domestic demand.

• Demand-diverting effects, moreover, relate to the change in relative prices between tradable and

nontradable goods, due to the impact of monetary policy on the nominal exchange rate. Such relative

price change entails a demand shift between tradable and nontradable goods and, thus, an impact

on the trade balance. A loosening of monetary policy, for example, entails a depreciation of the do-

mestic currency, an increase in the price of tradable goods relative to nontradable ones, and thus a

strengthening of the trade balance (through both a reduction of imports and an expansion of exports).

Because demand-augmenting and diverting effects entail opposite effects on the trade balance, the

overall impact of monetary policy on a country's external position is ambiguous and it depends on the

strength of each of these effects. Our analysis sheds light on this.

The methodological approach builds on the work by Ehrmann, Fratzcher, and Rigobon (2011) and

Matheson and Stavrev (2014), who identify monetary policy shocks in a vector autoregressive (VAR),

by exploiting information in asset prices. Specifically, the approach builds on the assumption that

bond and equity prices tend to decrease with unanticipated increases of the policy rate—or upward

revisions about expected future monetary policy—while equity and bond prices move in opposite di-

rections (increasing and decreasing, respectively) in response to positive cyclical shocks. The setting

FIGURE 1 U.S. monetary policy tools and interest rates, 1990–2016. Sources: Haver Analytics, FRED,

Krippner (2016), IMF staff calculations [Colour figure can be viewed at wileyonlinelibrary.com]